Bad NPA is a symptom not a disease!!

It generally happens quite often that we try to cure symptoms rather than the disease and believe that the disease will go away. Same is the case with many of public sector banks’ rising Non-Performing Assets (NPA). When most of the media & experts are fixated on “NPA” trouble, much less attention is paid as to what has caused such escalating NPA situation in first place. In true sense bad NPA is symptom which is reflection of the disease called “Nexus of bad credit analysis habits & outdated credit analysis and appraisal processes with poor loan monitoring, hyper competition among banks (aggressive lending practices), political pressure on public sector banks to clear the loans and bribe for the loan”. Main focus in this bog is on bad NPAs which are created because of any of the above reasons. Good NPA is genuine case of company which is struggling to repay the loan due to some external and internal business factors. Imagine that you have taken a loan from bank and after sometimes for some reasons you are unable to pay EMI for 3 months, then your loan will be called NPA. Further, banks are required to classify NPA under sub-categories which are; 1. Substandard assets (If EMI is not paid for 12 months or less), 2. Doubtful asset (If loan remains as substandard asset for 12 months), 3.Loss asset (As per RBI, "Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted”). I shall try to highlight the bad NPA disease and possible cure for it.

1. Bad credit analysis habits & outdated credit analysis and appraisal processes with poor loan monitoring: When RBI governor himself stated that laxity in credit risk appraisal and loan monitoring is one of the reasons for rising NPA, he was just re-confirming & accepting what everyone knew for years. By no means am I saying that only public sector banks (PSBs) have bad habit of credit analysis & appraisal with poor loan monitoring. Many of private banks are also burying the credit analysis &appraisal process. We all have received calls from private banks for pre-approved loans or instant loans and what not, the question strikes me have they done proper risk analysis & appraisal in each of this case? PSBs which are known for its laxity this problem is much bigger. Many of the credit analysis processes are outcome of bad habits of the person in charge for credit analysis and appraisal. Many of the PSBs are still in love with typical financial statement analysis (majorly done through various financial ratios) and to an extent 5 Cs (character, capacity, capital, collateral and conditions) analysis of credit. This was good in old time but in changing credit risk dynamics and constantly changing economic/sector/company dynamics, it is not going to be enough. Poor loan monitoring (for quantitative assessment) and not keeping in touch with borrowers (for qualitative assessment) has always been welcome activity at PSBs.

Cure: Much needed proposal from government to create stringent appraisal system for infusing efficiency and transparency in government owned banks is a welcome step. This change will go long way to clean up PSBs culture in general and credit analysis, appraisal and monitoring specifically. Time is ripe to create CIBIL like institution which has similar set of work scope but for all type of loans (mainly corporate loans & others) taken by other than individuals. This CIBIL like intuition can generate CIBIL like credit score through centralize system which is created based on borrower’s past history with repayments of the loan and other factors. With the help of centralized neutral agency's credit score at least wrong selection of the borrower (happens with many PSBs) which is also contributory to NPA can be discarded. Many questions are raised at various forums regarding inadequacy of existing mechanism to identify NPAs. Many of the banks including private ones use third party verification agencies’ services as inputs regarding borrower’s financial information, loan proposal etc. These inputs are considered important for lenders. In this case role of third party when it can easily get influence under unscrupulous borrowers or intermediaries has to be put under a scanner. Both the components which are ability to repay theloan and willingness to repay (willful default) the loan should be evaluated. Much is there in terms of checking financial ability to repay but nothing much has gone into understanding and evaluating the willingness to pay. Very interestingly and so far successfully psychometric test designed to gauge borrower’s mind set regarding loan repayment has shown way out for checking willingness to repay. Many of the new generation financing companies are using services of the firms for customized psychometric test for their set of borrowers. Banks can conceive the idea of separate loan monitoring & review unit, which can works towards first establishing fool-proof digitalized platform for monitoring & reviewing the quantitative (financial) and qualitative position on quarterly basis of the key borrowers. Timely review can help generate red flag in advance for the banks to behave more proactively than re-actively. At last, banks should be given more teeth by RBI to recover the bad loans(especially from willful defaulters).

2. Hyper competition among banks (aggressive lending practices): Most of the PSBs have jumped into competition (willingly or by force) among themselves and also with fiercely private banks. There cannot be controlled competition, so as the competition increases all types of banks are going to fight to retain & expand their business which is primarily attracting more & more deposits and extending more & more loans. System can ignore aggressive lending practices at its’own peril, and we do not have to go much back in the history to understand how perilous it could be. Credit crisis of 2008 is fitting example where cheaper cost of borrowing coupled with extreme hunger for business led financial institutions and banks stand ready to lend to virtually anyone interested. We all receive one way or another “pre-approved” loans proposals every now and then. To control the competition in this regards, might not be the wise thing to do, but to put up set of measures to safeguard the larger economic system and bank’s equity stakeholders is required.

Cure: To curb aggressive lending practices which are not that prevalent perhaps among PSBs but more in private banks, apart from regulatory measures there might not be much in arsenal to directly control it. Guidelines by RBI as to what types of corporate loans with various features & customized structures can be issued to what type of eligible borrowers can be first step. Linking person in charge & the credit team’s performance appraisal directly with portion of bad loans (which turned into NPA) approved by them, which may lead to negative appraisal can really curb blind aggressive lending practices. Even sales force’s performance appraisal can be linked with how many sound/bad borrowers they brought to the bank.

3. Political pressure on public sector banks to clear the loans and bribe for the loan:  What if Government sponsored a study report which has intention of identifying to what extent loans in PSBs are granted because of some sort of political pressure or with motivation of some sort of bribe.( I guess I am daydreaming!!!) When one sees that there are around 27 PSBs with the branches spread across India, one would drop the idea of trying to identify to what level the motive behind sanctioning the loan is due to some sort of political pressure or personal favor. Unfortunately, there is no way we can say how much of bad NPAs is getting contributed from this. But we don’t need proof for this, based on our personal experience we know, it has significant contribution to bad NPAs.

Cure: Best cure is to reduce GoI stake over some specified time period below majority from PSBs which can easily eradicate the political influence altogether on PSBs. If government continues to be the owner of the PSBs, then it will certainly burden country’s fiscal deficit as huge capital infusion is need to capitalize these PSBs against NPA and also for compliance with Basel III norms. Another interim solution until reducing GoI stake in the PSBs below majority becomes reality, is hire outsiders (Non- PSBs) at top management level and at mid- level to run the PSBs. One path breaking step taken by government is to separate the Chairman and the MD post which is in sync with global best practices to divided the power for better management supervisory & control.

Bad NPAs is a reflection that when ingredients like bad credit analysis habits with outdated credit practices coupled with aggressive lending practices come together what kind of distasteful dish is created which has garnishing of unending political favoritism and insatiable personal greediness. But this can also change!