Banks have incurred humongous losses in India. The public authorities have taken corrective measures primarily in the form of strengthening laws, audits, and the enforcement processes. In this article, Gurbachan Singh argues that while this is indeed required, at the margin there is a much greater and urgent need to improve assessment of the economic risks in a dynamic economy.
The non-performing assets (NPAs) in the banking sector in India are humongous. “…by 2014…in all, roughly 15 percent of state bank loans had gone bad” (Sharma 2016). In fact, regulators, banks, Government of India (GOI), courts, and firm managements are currently grappling with this issue. GOI has recapitalised public sector banks (PSBs) to the extent of Rs. 2.11 trillion. It has taken several steps in recent years to avoid or keep NPAs to the minimum in future. However, these corrective measures are primarily in the nature of improving the audit process so that frauds are caught or prevented. Even if it is assumed that frauds are prevented, there is another and even bigger issue of assessing the economic risk in giving loans in a dynamic economy.
Policy measures in the last few years
Let us consider the various corrective measures by the public authorities.
The Reserve Bank of India (RBI) carried out Asset Quality Review (AQR) in 2015. This was to basically examine if NPAs had been under-reported in the balance sheets of banks. This indeed turned out to be true. This review brought to the forefront the huge NPA problem in India.
The Insolvency and Bankruptcy Code (IBC), 2016 is the new bankruptcy law of India. The IBC is a one-stop solution for resolving insolvencies, which was earlier a long, costly, and ineffective process.
GOI set up National Company Law Tribunal (NCLT) in 2016. The NCLT is basically a quasi-judicial body, which adjudicates issues relating to companies in India. This is useful as the usual courts take very long.
GOI set up the Banks Board Bureau (BBB) in 2016. This is (supposedly) an autonomous body of GOI to improve the governance of public sector banks (PSBs), recommend selection of chiefs of such banks and financial institutions, and to help banks in developing strategies and capital-raising plans.
The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interests Act (SARFAESI Act), 2002 was amended in 2016. The amendment added new definitions to SARFAESI, widened the scope of debts and secured creditors, and bestowed new powers upon RBI.
Observe that all these measures are in addition to laws like the Indian Penal Code, The Prevention of Corruption Act, and so on.
Reaction to the more recent PNB story
More recently, an alleged scam has come to the surface in Punjab National Bank (PNB). The PNB story has further convinced the public authorities to strengthen the audit process in banks. Subsequently, the Fugitive Economic Offenders Bill is under active consideration by GOI; it aims to stop economic offenders who leave the country to avoid the due process of law. On 1 March 2018, the Union Cabinet approved a proposal to establish a National Financial Reporting Authority (NFRA) as an independent regulator for the auditing profession.
The alleged fraud in the PNB case involves a maximum loss of Rs. 113.94 billion; this is a gross figure which does not consider recovery of assets by the Enforcement Directorate (ED) to the extent of Rs. 63.93 billion. The maximum possible losses in the PNB story are not even 1% of the total bad loans. In a broader perspective, very few frauds have happened in banks in India and yet NPAs are humongous. Why?
Understanding the huge NPAs in India
Joseph Schumpeter taught us about the role of entrepreneurs, and the role of competition, and creative destruction in a capitalist economy. Many of these ideas apply even to mixed but dynamic and fast-growing economies like India; at least they do now even if they did not earlier during the heydays of economic planning, given the liberalisation and opening-up of the economy in one way or another since the early 1990s. It is not surprising then that many stock analysts, rating agencies, and professional investors are at work making updated assessments of listed firms; this is indeed what can possibly make a financial market efficient (Grossman and Stiglitz 1980). The assessments need to be carried out on an ongoing basis because technology, businesses, economy, and economic policies keep changing all the time. How does all this matter for banks?
The work of evaluating a firm is required not just in the stock market but also in banks. There are three reasons for this. First, banks cannot always rely on the analysis of others even if they have access to such analysis, which is anyway often not the case. Second, their needs can be different from those of the usual stock analysts as they are evaluating loans and not stocks of firms; it is the latter which interests stock analysts. Third, banks are dealing with not just listed firms but also unlisted firms; in fact, the latter can be more important clients given that listed firms may choose to issue bonds (and use external commercial borrowing) instead of taking loans from banks in India. Unlisted firms are typically not covered by the usual analysts. So, the banks need to do their own homework in assessment of economic risks and they need to go well beyond the reputations of businesses, which can change very quickly in a country like India these days. It is only then they can give loans somewhat safely.
Richard Koo, among others, has shown how, in a boom, equity prices go up, the debt of firms tends to rise, and firms tend to over-invest. If asset prices fall, then there is discomfort with what becomes a high debt-equity ratio. This then leads to a long-drawn-out process of deleveraging (Koo 2009). During this period, NPAs can rise. These can be prevented only by keeping in mind that the seeds of a downturn can lie in the boom itself (Shin 2010). This requires considerable restraint and discipline during the boom. This is another important part of assessment of risks by the banks at the time of giving loans in a boom. Indeed, the roots of many NPAs in India now go back as far as the big boom from 2003 to 2008 (and the subsequent downturn).
It is true that if financial markets are unambiguously efficient, then asset prices are right. In such a case, banks can rely on observed market capitalisation of firms and accordingly decide on loans to be given to different firms. (This can be done at least in the case of listed firms.) However, financial markets are, in practice, not unambiguously efficient (Shiller 2015). Under these conditions, lenders need to carry out their own independent analysis to evaluate firms instead of relying on stock prices, bond prices, and real estate prices. Then only they can keep NPAs to the minimum.
Real estate is an important asset anywhere. This is, a fortiori, true in an emerging economy like India. Many loans are given against real estate as collateral. Even where normal commercial loans are given to firms, bankers often have in mind the real estate holdings of such firms. These holdings are typically evaluated considering their market prices. It is expected that these prices will remain stable, if not appreciate, till the time the loan is supposed to be repaid. This premise is questionable (Singh 2016, and references therein). Accordingly, there is again a need for banks to carry out an independent valuation of the real estate assets of firms, which is based on ‘fundamentals’. Then risk assessment is better and NPAs can be reduced to a very low and manageable proportion of total loans.
Let us provide a perspective at this stage. Economic risks matter. They can lead to large bank losses if the risk assessment is not carried out seriously. Economic risk assessment requires personnel who are meaningfully educated, experienced, competent, insightful and visionary. Unfortunately, these qualities are often missing among many bankers. This needs to change. Economic risks are present even if frauds are kept under check. It appears that this rather simple economic point is getting missed in policymaking that is directed at the issue of large NPAs in India. The focus of the public authorities is instead on keeping a further check primarily on frauds; this does not help very much.
Last but not the least, there is an issue of appropriate incentives for bank managers to make a proper assessment of risks, avoid NPAs, and avoid a delay in recognition of NPAs, if these do arise (Banerjee and Duflo 2014). In this context, a further tightening of the audit process can discourage and demoralise honest bank officials; this may aggravate and not resolve the problem of large NPAs.
Lessons from elsewhere
It is interesting that fraud (and weak audits) played a very small role in the financial crisis in the US in and around 2007. We can barely recall a few names such as Bernard Madoff and Rajat Gupta in the context of frauds or illegal practices around the time of the financial crisis in the US. The bulk of the crisis had little to do with fraud (this is not to say that there was no moral wrongdoing in the US). Some researchers have related the financial crisis to neglected economic risks (Genaioli et al. 2012). There is a lesson in all this for India: there is a need to pay attention to financial economics and not just to issues of accountancy, procedures, audits, and legality.
- Banerjee, Abhijit V and Esther Duflo (2014), “Do Firms Want to Borrow More? Testing Credit Constraints Using a Directed Lending Program”, Review of Economic Studies, 81(2):572-607.
- Gennaioli, Nicola, Andrei Shleifer and Robert Vishny (2012), “Neglected risks, financial innovation, and financial fragility”, Journal of Financial Economics, 104:452-468. Available here.
- Grossman, Sanford J and Joseph Stiglitz (1980), “On the Impossibility of Informationally Efficient Markets”, American Economic Review, 70(3):393-408. Available here.
- Koo, RC (2009), The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession, Revised Edition, John Wiley and Sons.
- Sharma, R (2016), The Rise and Fall of Nations – Ten Rules of Change in the Post-Crisis World, Allen Lane.
- Shiller, RJ (2015), Irrational Exuberance, third edition, Princeton University Press, New Jersey.
- Shin, HS (2010), Risk and Liquidity, Clarendon Lectures, Oxford University Press, New York.
- Singh, Gurbachan (2016), “Land Price, Bubbles, and Permit Raj”, Review of Market Integration, 8(1&2):1-33.