Insulating Banks from Non Performing Assets

Origins of Banking & The Concept of Shadow Banking

The meaning of the term bank has its origins in confidence or faith. To bank means, to keep safely, like in a safe deposit vault. Associated with the term is trust. It is assumed that money kept in the bank is as safe as money kept in the house locker, except that there is no fear of theft. A banking company means any company which transacts the business of banking in India. Banking means accepting, for the purpose of lending or investment, deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise (The Banking Regulation Act, 1949).

Another associated term is ‘shadow banking’ which is doing banking activity, but the shadow bank cannot accept deposits repayable on demand. Popular shadow banks are non-banking financial companies and others who also access public money through deposits and lend to others. However, the term ‘shadow bank’ is a misnomer, since the protection available under deposit insurance is not available for NBFC deposits.

Winding Up Hierarchies: Companies Act 2013 vs Insolvency & Bankruptcy Code 2016

Under the Companies Act 2013—Chapter XX Winding up of companies—U/s 326 and 327, priority creditors (employees, taxes due to government, etc), secured creditors and then unsecured creditors will get paid in the order of preference. However, these sections will not apply to winding up under Insolvency and Bankruptcy code, 2016. This article will discuss the impact of such exclusion; it will discuss in detail whether the exclusion was for speedy resolution or for abrogation of rights of secured creditors.

The Bankruptcy and Insolvency Code 2016 classifies debts as financial debts and operational debts. The financial creditor may make an application to initiate corporate insolvency process. The resolution professional shall constitute the committee of creditors. U/s 21, decision of committee of creditors shall be through vote, with 51% being the requisite voting share for a resolution. When Insolvency and Bankruptcy code was introduced to expedite the recovery process, it is a point for further debate on whether it diluted the position of secured creditors. Also to be considered is whether the property rights can be abrogated, as secured creditors preferential claim on such assets, except in the case of public interest.

Loan book may comprise of individual loans for asset purchase or loans to corporates. In case of individual loans, collateral is the asset (financed asset is normally offered as collateral, while for corporate loans, the security will be charge on the assets or it can also be unsecured loans. For loan book, the security value will depend on the replacement cost or disposal value, and utilisation/earnings from such assets will result in prompt loan repayment, including servicing of interest cost. Various factors may result in erosion in value of assets and drastic variation in earnings. However, larger the number of loan transactions, possibility of few loan portfolio turning bad may not adversely affect the financier.

Valuation Principles & Market Dynamics

Asset valuation will depend on replacement value or realizable value of the asset, when put up for sale. Business valuation will depend on market conditions and replacement cost. However equity valuation depends on market, growth and earning visibility and market price is mostly factored on future earnings. Normally pledging of equity shares is private borrowing. Margin requirement on this front sometimes play havoc on market price. Fall in equity price result in lower margin. When lenders resort to sale of equity in the market, it will further depress the market price. With listing of equity instruments, market value determines the value of shares; of course, control premium, etc. may play a role.

In the eighties and nineties, corporates used to publish accounts on historical basis. This is before the advent of fair value reporting and if no revaluation of assets has been done by the corporates, there used to be huge difference between book value and market value. This resulted in hidden reserves i.e. valuation difference. However present day accounting, viz fair value method has narrowed this gap.

Another factor is the emergence of the knowledge sector i.e. advent of asset light companies. With novelty, these companies enjoyed attractive valuation in the stock market. Being asset light companies, normally financing was from equity market.

Evolution of Banking & Financial Ratio Benchmarks

Entrepreneurship is the cause for business enterprises. When an enterprise is started with one’s own capital, entire risk is borne by the entrepreneur. When additional funds are required, borrowing is an available option. Persons with resources, lacking direct entrepreneurial appetite, lend amount to meet business requirements (though lending also is a business enterprise).

Banking as a business evolved when some enterprising individuals turned lending to a business enterprise and such business enjoyed the return differential between loans and deposit interest rates. Even under corporate structure, shareholders are real owners and risk of failure is entirely borne by them. The lenders or financial creditors are to be paid in case of liquidation and then remaining amount is distributed to shareholders.

Debt-equity ratio, thus, became one of the measures to determine the safety and security of loan assets. In addition to debt-equity ratio, lenders were also concerned with interest coverage and liquidity ratios. Free cash flow is supposed to provide sufficient cover for interest obligations and repayment obligations and cover of more than 1 was deemed to be safe for the loan creditors.

Structural Differences: Long-Term Project Financing vs Working Capital Financing

Borrowing is of two types—long term borrowing (which normally is to finance acquisition of assets/business undertakings) and short term borrowing (which normally is for working capital financing). Forty/Fifty years back specialized category of financier was there for long term loans viz ‘Financial Institutions’. At that time, banks used to focus on working capital loans viz. short term borrowings. Financial institutions which used to specialize on long term loans will have appraisers who used to carry out project evaluation.

While short term loans focus on security of asset (existence and adequacy of asset, loan repayment through liquidation of asset) while long term loans used to focus on revenues and cash flows for repayment of loans. Asset valuation used to be the focus for short term loans while business valuation was the norm for long term loans. Asset valuation is a simpler process compared to business valuation which is complex. Sales realization is used for liquidation of working capital loans while free cash flow was used for term loan repayment.

Working capital loans used to be rolled over since the business which is going concern will require funds on a continuous basis. To illustrate, funds from sales realization was used for further purchase of goods for manufacture/trading. Safety/security of working capital loan will depend on sales realization and hence focus used to be on existence of current assets and their quick turnover. Project loan assessment used to focus on project completion and free cash flow while working capital assessment by banks used to focus on net current assets and their quick realisability.

Business growth was normal growth (both inflation and real growth) and expansion. Capex for capacity addition was different from capex for asset replacement and project loans were used for capacity creation/addition. The differentiation assumes significance since evaluation tools required for long term loans and short term loans are different. While there will be greater emphasis on asset utilization and cash flow for short term loans, asset valuation and margin is more relevant for long term loans.

Liquidity requirement of lenders also plays a part. Lender who may not face immediate liquidity pressure may wait for turnaround which may help to ward off the threat. It may be noted in the recent Union Budget, the Finance Minister highlighted the establishment of Development Financial Institution (DFI) to focus on infrastructure financing, viz long term loans.

Project Financing: Requirement of funds for setting up of project by industrial houses, viz., acquisition of land, plant & equipment including commissioning thereof. Capacity utilization used to be progressive over 2-3 years, by scaling up of production. Risk assessment was primarily on project delays and output meeting standards. Asset which comprises of land/buildings & plant and equipment used to appreciate (mostly land/buildings). Only when the industry turns sick, the loan recovery used to be in problem. However, the value of security used to cover the loan liquidation and loss, if any, was borne by equity shareholders. Normally loans get priority on repayment and liquidation proceeds used to be first applied towards loan repayment leaving the surplus to the equity holders. Shortfall in realization of assets used to be borne by the equity holders.

Banks Lending & Fiduciary Responsibility Towards Depositors

Banks lend money out of deposits which is their borrowings. When one deals with other peoples’ money, one acts as trustee or custodian and has to exercise utmost care and caution. When loans are written off by public sector banks or for that matter even by private sector bank, the write off decision affects the interest of depositors. Deposit insurance by banks is one way to protect the interest of depositors. Risk on unsecured loans granted by banks are borne by the depositors and hence at least to that extent, banks should have deposit insurance.

When agricultural loans are waived due to crop failure, crop insurance is necessary to mitigate the losses. Furthermore, every bank must have a policy on unsecured loans and this must be included in their published accounts. Bank boards must specify the limit of unsecured advances by the bank and this limit should be well below the capital of the bank. This is to ensure that depositors’ money is protected. Micro finance may be warranted to ensure credit for weaker sections of society; however all such unsecured loans and advances pose a risk to depositors and hence to that extent banks should have deposit insurance cover. Since banks lend out of depositors money, the policy directive by central banks or government intervention is not an ideal situation. Such funding requirement should be ideally met out of government revenue through subsidies.

Industrial Land Allotments and Reversion to Government

Another connected issue is whether land allotted for industrial purpose by State Governments should vest back to government in case the purpose is not met. The State Governments allot land and grant approvals/clearances for setting up industries as industrial activity generates employment (both direct and indirect), and hence such allotment/approval serves the public interest. In such a case, such allotment/approval is like a conditional sale and whether the land should vest back to government in case of project failure/liquidation is a matter which has to be debated. There is merit in the argument that the land should vest back to government so that the same can be allotted to some other undertakings which will fulfil the objective of employment generation in the local are. Proper rules have to be framed in respect of cases where land was allotted at concessional or preferential basis, citing public interest, for setting up industries.

Project Stage vs Operational Stage Risk Profiles

Risk factors which are to be assessed will be different during the project stage and operational stage. Assuming a power project, the risk factors during project stage will be a) Project completion time of 4 years; land acquisition/allotment, building construction, plant & equipment installation (which will depend on the supply commitment of the manufacturer) etc. Once the trial production is achieved successfully, the risk will shift to operational factors like fuel supply; transportation; transmission to grid, operational power purchase agreement, etc. Hence the loan appraisal/monitoring will have to focus on different parameters during project stage and operational stage.

It is important to note that the time for course correction is very small. Also recessionary trend cannot be easily predicted and may occur because of several reasons beyond the control of the project authorities. I am not able to visualize any form of insurance to mitigate the impact of unforeseen economic recession on project overruns. If factors like economic recession is the cause of project delay resulting in NPA issues, can we blame the decision making process in loan sanction? We need to revisit the policies/procedures in such a case to see how the problem can be addressed. The solution will be to complete the project operational so that the losses can be minimized. However, the action cannot be after prolonged delay.

The New Age Economy: Financing Asset-Light & Services Businesses

In the new age economy, the services sector account for substantial proportion of GDP. If a new airline operator enters the market with leased aircrafts, what will be assets owned against which they can borrow? The borrowings will then be only for operations and the financing is akin to working capital finance. The loan evaluation cannot be as project finance since there is no physical asset to finance but only operational expenditure to cover.

Hence a lot will depend on revenue stream and alarm bell should ring if the cycle is broken. Risk assessment should focus on gross revenue stream and operational expenses (including fixed cost like space etc.). Such projects should have more equity component and loan amount should have collateral security.

Disclosure, Transparency & Infrastructure BOOT Model Vulnerabilities

When corporates borrow (access public money), there has to be accountability. Recent cases of NBFC and Housing Finance Companies liquidity issues highlight the importance of need for further regulation on matters of governance, disclosure & transparency. Creation of step down subsidiaries and borrowings by one corporate and ultimate utilization by some step down subsidiaries create problem of monitoring the funds utilization. Since what is lent is the public money, such disbursal has to be effectively monitored.

Currently infrastructure projects like airports, roads etc. are built under BOOT model (build, own, operate and transfer). Since most of these projects are public utilities, contracts are awarded based on cost competitiveness. However, there is no prohibition to transfer the project mid-stream. Transfer of projects actually pushes the enterprise value and when the buyer resorts to borrowings, the security cover comes down. How these transactions are not only against public interest but places lenders in a vulnerable position leading to NPAs will be a fit case study for further research.

Corporates which are putting up the project should also exercise due care and caution and select projects based on the viability. Extra care is required where project requires loan funds. If investment decisions are made objectively, possibility of loss will be minimal. The debt-Equity ratio indicates the cushion available for lenders. Further when banks look for unsecured loans (either as priority lending or as economic compulsions), the possibility of bad debt is very high. Hence bank boards should set limit for such unsecured loans in their loan portfolio.

Companies Act 2013—Chapter XX deals with winding up of companies and both voluntary winding up and compulsory winding up are covered in that chapter. The purpose of winding up is to have speedy resolution of stressed cases. While loan creditors get preference on distribution over owners, viz. shareholders, even creditors are categorized into preferential, secured and unsecured creditors and the order of preference is set for distribution of monies. The Insolvency and Bankruptcy code was brought into statute book with the express objective of speedy resolution. Once Insolvency resolution process is started, the resolution may be either by sale of undertaking or liquidation by means of sale of assets of undertaking.

Secured creditors rights are protected by Sec 52. Time bound settlement will ensure that stressed assets are transferred before further deterioration in value. Secured loans will enjoy preference at the time of liquidation/resolution. To the extent of coverage of security, secured loans will enjoy preferential repayment. However the method of distribution is decided in the meeting of creditors and resolutions are put to vote and are passed with 51% of voting. What happens when unsecured creditors are in the majority and block resolutions for distribution? Secured creditors should have preference over distribution from such covered assets sale proceeds and surplus, if any, only should be transferred to general pool.

Chapter VI of Companies Act 2013 covers registration of charges. Sec 77 casts an obligation on the company to register the charges created with the Registrar of Companies. Sec 370 of the Companies Act 2013 provides for 2 modes of winding up, viz by the Tribunal or voluntary winding up. Interest of secured creditors are maintained and not vitiated. Hence the Insolvency and Bankruptcy code, which incidentally was placed in the statute book for quick resolution of insolvency cases, will have to be deemed to be in favour of creditors and liberal interpretation in favour of creditors must be placed.

NBFC/HFC Crisis, Corporate Guarantees & Rating Agency Accountability

Growth of intermediaries like non-banking finance companies, housing finance companies, etc. is mainly on account of requirement of funds that were unmet by banks. These are types of shadow banking and initially they were regional players but over time, some of the companies reached size and became national players. Most of the finance companies borrowed from the market through public deposits, debentures etc. However, some part of their requirement was also met by banks and banks looking for bulk customers started patronizing them. In the deposit/loan cycle, when the borrower defaults, then the finance company also will not be able to meet their obligations. Whether such indirect lending by banks for further lending by finance companies is desirable or not will depend on prudential norms followed by such finance companies and also on quick resolution of cases where default is there on loans from such intermediaries.

Whether ILFS or very recently DHFL, the holding company created subsidiaries, step down subsidiaries, etc. and in some cases also SPV (special purpose vehicles, for a particular bid/execution), the subsidiaries were able to borrow based on parent’s corporate guarantee which means that they enjoyed substantial borrowing limits. How much of a corporate guarantee a company can offer? When the parent company itself is a limited liability company, can it offer unlimited guarantees to its subsidiaries? There should be a limit for such guarantees, whether by banks, financial institutions or even corporates.

In bankruptcy code resolution, when the provisions of the Companies Act concerning winding up is specifically excluded, what happens? Will it mean that secured creditors will lose their rights and preferences? The rights of secured creditors are not merely governed by Companies Act but by Law of Contract and securitization rights. These rights are not superseded and hence the right of secured creditors over the assets will rank first and surplus, if any, will only have to accrue to unsecured creditors.

When subsidiaries borrowings are covered by corporate guarantee, the parent company must make proper disclosure of this fact together with the limits of such guarantees provided. Further the auditor must comment on going concern concept after taking into consideration such corporate guarantees and the likely cash flow of such subsidiaries. Rating agencies, when they provide rating, must be held accountable for such rating and there should be deterrent for such rating agencies when they suddenly change the ratings.

Endnote & Practical Imperatives

The fundamental question of safety and security will remain the focal point. Debt-equity coverage will insulate the loan amount to the extent of coverage. Whether banks and other lending agencies who access public money can lend money without security is a question which has to be answered if we have to find the solution to NPA issue. To the extent of unsecured loans, banks should have deposit insurance cover to ensure that depositors’ monies are protected.

Timely and corrective action will ensure that the loss amount will be minimized in case of loan default. Lenders must focus on book value and also market value to effectively monitor the debt-equity ratio and interest coverage ratio. Even to realize amount of secured loans by possession and disposal of secured assets is fraught with delays and such delays result in deterioration of asset quality and their realizable value. Speedy resolution of disputes will go a long way in minimizing losses to the lender.