BANCON 2013 Two decades of credit management in banks: Looking back and moving ahead

1. BANCON 2013Two decades of credit management in banks: Looking back and moving ahead K.C. Chakrabarty Deputy Governor Reserve Bank of India

2. Introduction • Business of banking is business of intermediation • Credit risk is integral to banking business • When banking was simple • Lending decisions - made on impressionistic basis • Credit risk management – straightforward • Information requirements – minimal • As banking became diverse, complex, sophisticate • Risks increased, became transmitive and contagious • But, credit risk management – lagged behind • And, information systems – remained primitive and did not capture granular data correctly

3. Objectives • Examine how Indian banks have dealt with credit risk over the last two decades • Evolution of regulatory framework • Analyse trends in asset quality of Indian banks • Trends in gross and net NPAs • Trends in slippages, write offs and recoveries • Trends in restructuring • Dwell on some facets that have a bearing on the asset quality of banks • Risk management and primitive information systems • GDP growth trends • Size / segment analysis of impaired assets • General governance and management structure • Credit appraisal and monitoring standards • Way forward for the regulators, policy makers, banks and bank customers

4. Evolution of NPA regulation in India

5. Prudential norms for NPAs • 1985 • First-ever system of NPA classification - ‘Health Code’ system • Classification of advances into eight categories ranging from 1 (Satisfactory) to 8 (Bad and Doubtful Debts) • 1992 • Prudential norms on income recognition, asset classification and provisioning introduced • Restructuring guidelines introduced • Assets, where the terms of the loan agreement regarding interest and principal is renegotiated or rescheduled after commencement of production to be classified as sub-standard • 2001 • 90 day norm for NPAs introduced (effective from March 31, 2004) • specified asset classification treatment of restructured accounts tightened

6. NPA trends – Reflecting regulatory initiatives • NPAs rose when prudential regulations introduced - reduced thereafter as regulatory initiatives facilitated improved credit risk management by banks • Pace of introduction / tightening of regulatory reforms slowed after 2001 • Regulatory norms were not further tightened during the “good” pre-crisis years • Reflected in poor credit standards and increased delinquencies • Provisioning levels remained low for the Indian banking sector • Norms with regard to floating provisions changed • Provisioning coverage ratio was introduced but relaxed thereafter • Dynamic provisioning coverage yet to be introduced • Mere tweaking and flip flop approach to Prudential norms • Restructuring increased as regulatory requirements were relaxed, especially in the post crisis years • One time special dispensation for asset classification of restructured accounts provided to deal with the impact of the global financial crisis

7. Trends in asset quality

8. Trends in gross and net NPAs • Early 1990s • NPA ratios rose • Immediate impact of prudential norms • Thereafter, the NPA ratios declined • Improved risk management • Increased write offs • Rising credit growth / robust economic growth • Abundant liquidity conditions • Increased restructuring • In recent years, NPA ratios have been rising, though on an average, the ratios are not higher

9. Divergent bank group wise trends • 1996-2003 – wide variation between NPA ratio of PSBs and other bank groups • 2003-06 - NPA ratios of all bank groups moved in tandem • 2007-09 – NPA ratios begin to decouple • After 2009, gap between PSBs and other bank groups started rising

10. PSBs – growing asset quality concerns • PSBs share a disproportionate and increasing burden of NPAs – especially in recent years

11. Looking beyond the veil of headline numbers Gross and net NPAs numbers have limitations! • In the 1990s, only data about gross and net NPAs were available • Subsequently, data on flow of NPAs (fresh accretions and recoveries) collected, followed by data on restructuring, which allowed better understanding of the real problem of credit management in the banks • A more detailed understanding of trends in asset quality of banks required collection and analysis of granular data about various aspects of NPA management viz. Slippages, Write offs and Recoveries – Segment wise and activity wise • Such data has been collected only in recent years(since 2009), largely due to regulatory impetus • The current analysis is an attempt to examine trends in asset quality based on this detailed information

12. NPA movement over the last decade • Increasing slippages and write offs since the crisis years • New accretion to NPAs exceeds reduction in NPAs post crisis

13. Slippages … Trends • Slippages – better metric to assess credit management • Slippages & net slippages • Showed a declining trend in the early 2000s; started rising since 2006-07

14. Recovery efforts deteriorating • Extent to which banks able to reduce NPAs through recovery efforts deteriorating • evidenced by increasing ratio of slippages to recovery and upgradation Average Slippage to (Recovery + Upgradation) Ratio

15. Recovery & write offs – associated moral hazard • Write offs contributing significantly in reduction in NPAs • Reducing incentives to improve recovery efforts • Slippages exceeding reduction in NPAs especially post crisis • The trends indicate weaknesses in credit as well as recovery management

16. Write-Off and recovery from Write-offs Substantial Write-off but recovery from write-off has been very poor

17. Divergent bank group wise trends - slippages • In the aftermath of the crisis, slippage ratios rose, especially for FBs and NPBs • FBs and NPBs, though quickly arrested deterioration in asset quality post-crisis through improved credit risk management • In recent years, the ratio rose sharply for PSBs Slippage ratio = fresh accretion to NPAs during the year to standard advances at the beginning of the year

18. Divergent bank group wise trends – net slippages • Recovery performance also varied across banks as revealed by trends in net slippages Net slippage ratio is slippage ratio net of recoveries

19. Divergent bank group wise trends – slippages and fresh restructured accounts • The bank group wise trends in slippages are further re-enforced when the trends in slippages and fresh restructuring are examined Slippages + fresh restructured ratio

20. Summing up… • Standards of credit and recovery administration is inefficient and poor as is reflected from the fact that upgradation as a % of slippage is very low – only less than 20 % of accounts have been upgraded • Recoveries are very less- A major part of reduction is through write-off • Even during 2001-07, recoveries and upgradation were not as good-things have considerably deteriorated thereafter • Gross NPA in itself not a problem but in conjunction with restructured advances they have emerged as a major issue

21. Restructured Accounts … Trends • Growth in restructured accounts • mixed trend in early 2000s • sharp uptick in 2008 / 2009 due to the one time regulatory dispensation • Continued high growth rate thereafter

22. Restructured Accounts … Use and Misuse • Forbearance a necessity, especially for viable accounts facing temporary difficulties • But, increasing evidence of misuse of facility for “ever- greening” of problem accounts by banks • Restructuring of unviable units • Deserving & viable units especially for small borrowers get overlooked • Promoters contribution to equity not ensured • Restructuring increasingly used as a tool of NPA management by banks

23. Divergent bank group wise trends in restructuring and write -off • Asset quality deteriorates further if restructured accounts and write offs are included, especially in the case of PSBs • Banks which are more aggressive in identifying NPAs appear to be able to manage them better Impaired Assets ratio = (GNPA + Restructured Standard Advances +Cumulative write off) to (Total Advances + Cumulative write off)

24. Summing up….. • Only less then 10% of the total amount written off (including the Technical Write-off ) is recovered • The amount of restructuring and write –offs distorts inter-segment comparison of credit quality • Technical write –off creates moral hazard and creates a dent in overall recovery efforts • Banks should be given the freedom to decide whether the cases involve restructuring - where only the technical covenants of the loan or the date of commencement of commercial production might have changed and the banks are convinced that the pay-offs from asset created will be sufficient to repay the loan - Cases where the reduction does not bring down the lending rate below base rate should not be considered as concession I 24

25. Segment wise NPA Trends • Deterioration in asset quality highest for industries’ segment • Though banks devote fewer resources to the administration of small credits vis-à-vis larger credits • Within industries segment - deterioration driven by medium and large enterprises (50% share in NPAs) Impaired Assets ratio

26. Infrastructure finance – significantly affected Impaired Assets ratio Infrastructure projects – strain on banks • regulatory, administrative and legal constraints • Banks’ took inadequate cognizance of the need for contingency planning for large projects in their appraisal • absence or insufficiency of user charges

27. Large ticket advances – greater share in restructured accounts • Restructuring – provided primarily to large corporates • medium and large accounts make up over 90 per cent of restructured accounts • larger ticket accounts hold major share in CDR * The data for ‘Medium & Large’ and ‘Micro & Small’ pertains to Industries and services sectors.

28. Asset quality worse for Directed Lending – A myth • General belief is that directed lending has contributed to rising NPAs • GNPA ratio higher for priority sector than non-priority sector • However, considering restructured accounts and write offs, asset quality worse for the non-priority sector Priority sector Non Priority sector

29. Study Conclusions & Other Issues : Why high NPA and such poor state of Credit Management?

30. Primitive Information Systems • Improvements in information systems were not coincident with increased size of asset portfolio, increasing complexities in credit management • Banks ability to manage the quality of their asset portfolio remained weak given • The lack of granular data on slippages, early indications of deterioration in asset quality, segment wise, trends, etc. • Banks failed in identifying / arresting the early pre-crisis trends – from 2005-06 - in asset quality deterioration

31. GDP slowdown leading to increased NPAs! Recent decline in asset quality coincided with deceleration in GDP growth

32. Higher NPAs only a result of GDP slowdown? Beginnings of deterioration in asset quality started ahead of slowdown in economic growth Growth rate of GNPAs started rising before the crisis even as the pace of slippages turned sharply positive in 2006-07

33. Asset quality of PSBs – Economic downturn or sub-optimal credit management? • Recent increase in NPAs not reflected across all bank groups • Though economic downturn faced by all banks • Early threats to asset quality - swiftly and effectively managed by private sector and foreign banks • PSBs suffer from structural deficiencies related to the management and governance arrangements • Reflected in lacunae in credit management • Pre-dates the crisis, but not dealt with on time, unlike in the case of the FBs and NPBs

34. Lax Credit Management • Deficiencies in credit management crept in during the pre-crisis “good years” • In general, banks with high credit growth in 2004-08 ended up with higher NPA growth in 2008-13 • The appraisal process failed to differentiate between promoter’s debt and equity • Promoters equity contribution declined / leverage higher • Credit monitoring was neglected • Recovery efforts slowed • Legal infrastructure for recovery remained non-supportive • Restructuring became rampant OPB NPB PSB FB

35. Increasing frauds – or are they business failures? • Increasing incidence of frauds, especially large value frauds in recent years • Over 64 % of fraud cases are advances related – over 70% in case of large value frauds (over Rs. 50 crore) • Poor appraisal and absence of equity has led to larger no. of advance related frauds especially through diversion • Moral hazard associated with identifying business failures as frauds • Lacunae in credit appraisal not identified • Fixation of Staff accountability a casualty

36. Credit appraisal suffered…(1) • Poor Credit appraisal at the time of sanctioning as also at the time of restruturing • Significant increase in indebtedness of large business groups • Sample of 10 large corporate groups - credit more than doubled between 2007 and 2013 even while overall debt rose 6 times • Credit growth concentrated in segments with higher level of impairment • Lending elevated in several sectors where impairments were higher than average Source : Credit Suisse Research

37. Credit appraisal suffered…(2) • Indian corporates - accessing international markets to raise capital • Risk from un-hedged exposures • Risk from increase in interest rates • Impact could spill-over to lenders • Project risks not taken due cognizance of • Contingency planning for large projects • Restructuring extended to large corporates that faced problems of over-leverage and inadequate profitability • Companies with dwindling repayment capacity to repay debt - raising more and more debt from banks • ability of corporates to service debt was falling • exposure of companies to interest rate risk was rising

38. Summing up….. • High credit growth in select sectors has led to decline in credit quality in subsequent periods • High incidence of advance related frauds are an outcome of deficient credit appraisal standards • Level of Leverage of corporate borrowers, credit growth, diversion of funds, sub standard assets and fraud cases are highly correlated. They are first order derivative of improper credit and recovery management

39. Assessing the resilience of the banking system

40. Resilience of the banking sector…(1) • Current NPA levels - not alarming though could pose concern if current trends persist

41. Resilience of the banking sector…(2) • Stress testing reveals resilience of banking system due to strong capital position

42. Resilience of the banking sector…(3) Provision coverage ratios of Indian banks low by international standards – declining in recent times

43. Stressed Assets Provision Coverage Ratio Provision Coverage Ratio presents a dismal picture when Restructured Standard Advances are also considered Stressed Assets Provision Coverage Ratio defined as {(Total Provisions (excl. Provision for std adv) + Tech W/Os) to (GNPAs + Rest Std Adv + Tech W/Os)}

44. Recommendations and Way ahead

45. Recommendations and way ahead • Short run • Addressing the existing stock of impaired assets – NPAs and restructured • Time bound revival or recovery • Long run • Robust risk management • Improved information system • Facilitating granular analysis of trends in asset quality • Improved credit management • Credit appraisal and monitoring • Facilitative regulatory and legal infrastructure

46. Short term: Review of NPAs / restructured advances • Assess viability of NPA and restructured accounts – on case-to-case basis • Pre-stipulated time-frame for review/ restructuring • Accounts found viable • Promoters to assume their share of losses - not resort to further borrowing for equity • If need be bring new promoters • Burden to be equally shared • Restructuring of small accounts - Reorient restructuring towards small customers – SMEs, priority sector • Accounts found to be un-viable • Put under time bound asset recovery • banks takeover of units where promoters’ equity is low • sale of assets to ARCs

47. Improve credit risk management Enhanced Credit Appraisal • Group Leverage, Source/ structure of equity capital • Complex project structure (as in SPV) • External constraints – effective contingency planning • Keep a check on credit growth and linkage with equity Need for quicker decision making • Appraisal, sanction, disbursement - timely and fast • More compassion to smaller borrower and increased stringency for larger borrowers Strengthen Credit Monitoring • Comprehensive MIS and Early Warning Systems to facilitate regular viability assessment Enforce accountability • Accountability on Individuals and all levels of hierarchy • Accountability to encompass all aspects of credit management • Accountability for delayed decision making / non-action

48. Improved information systems • Information systems – the backbone of credit risk management • Robust information systems needed • Facilitate more intensive data capturing • Integrated into decision making, capital planning, business strategies, and reviewing achievements. • Enable timely detection of problem accounts, • Flag early signs of delinquencies, • Facilitate timely information to management on these aspects • Coordinating mechanism across departments within a bank and across banks • MIS for capturing common exposure across banks

49. Regulatory framework • Need to review the existing regulatory arrangements for asset classification and provisioning • Facilitative and practical regulation • Restructured accounts to be classified as NPA – aligning domestic norms with global best practices • The practice of technical write offs of NPAs to be dispensed with • Increased provisioning requirements in line with international norms and to ensure resilience of the banking system • Uniform approach to regulation – either principle or rule based • For stability in credit risk management practices • To eliminate ad-hoc implementation processes

50. Reforming legal & institutional structures Corporate Debt Restructuring (CDR) mechanism • Remove existing bias towards large-ticket accounts • Ensure viability and promoters’ stake upfront • Independent oversight of large CDR account Debt Recovery Tribunals (DRTs) & other legal provisions • Need for vigorous follow up in the case of suit filed accounts • setting up of more DRTs and DRATs Asset Reconstruction Companies (ARCs) • Review and revitalise functioning of ARCs Credit Information Companies (CICs) • Expand use of CICs for credit management