Reviving the health of the banking sector is of utmost importance – REUTERS
Banks need to reset their loan appraisal processes. Regulators should step in to curb excess lending in exuberant times
In continuation of the article published yesterday (August 3), we examine further the factors that may be contributing to the accumulation of NPAs in banks and the steps to be taken to prevent it.
Outsourcing credit monitoring
Many banks have started engaging external Credit Monitoring Agencies (CMA) to help address these issues. It is seen that some of the banks have provided a check list to these agencies that contain as many as 60 parameters (to be precise 63 parameters in the case of one bank). But this should not be reduced to ticking the box compliance. It is important to separate signals from noise so that effective remedial interventions are designed and enforced at the right time and this can be done only by the lenders and cannot be outsourced.
The current threshold of ₹250 crore for outsourcing may be reduced to ₹100 crore as this segment has also its fair share of NPAs, frauds and bedevilled with similar problems.
Read also: Preventing the pile up of NPAs — I
Early warning signals framework
RBI introduced SMA (Special Mention Accounts) framework in 2002 to identify incipient stress. But this framework has not helped in stemming the build-up of NPAs. Probably these signals are not aligned with monitoring tools or business performance parameters. Signals should lead to a deeper Root Cause Analysis.
Role of supervision
Regulatory forbearance needs to be nuanced to distinguish between cyclical and secular factors impacting some of the industries. For instance, steel prices reached a peak of nearly $1,000 per tonne and crashed to as low as $300 by 2012. This had pushed a good number of steel units into deep red and the units turned NPAs. Many of these units were disposed of to other units through Insolvency and Bankruptcy Process and in the process lenders suffered huge haircuts of over ₹1 lakh crore. But now the prices have again spurted to over $1,000 per tonne.
On the other hand power producers have suffered huge losses as the power prices crashed by almost 70 per cent and never to recover and in fact further deteriorated. Now with emphasis on renewable power and carbon reduction obligation most of the fossil fuel based plants have only bad days ahead. This is a classic case of secular decline and banks have suffered massive haircuts.
RBI mooted the idea of Risk Based Supervisor during 2004. This was implemented in some of the banks in 2014. The time gap between idea and implementation can be shortened.
RBI may consider exchange of its officials with commercial banks for 2-3 years to gain a better operational perspective.
Banks have set up specialised branches for corporate and industrial finance. But this model did not help as evident from the pile up of NPAs at these branches. Many of these specialised branches have turned major NPA centres.
Governance and High Conduct Risk
RBI in April 2021 came out with a series of measures to improve governance. These measures include enhanced role to Independent Directors (IE), the manner of their appointment, reconstitution and chairing the committees, frequency of the meetings, avoiding conflicts of interest and intense scrutiny of related party transactions, accountability for lapses etc. But many positions of Non-Executive Chairman and Directors are lying vacant for long. In the absence of adequate number of Directors, these guidelines are beyond effective implementation. Banking Bureau (BBB) may be entrusted with the responsibilities to fill up all vacancies of non executive chairmen, Independent and Non- executive directors. Without full complement of the Board, good governance may be a casualty.
The new Governance advisory lists out 30 Dos and Don’ts for Directors. But in practice just one risk — Conduct Risk — overshadows all other risks and compliance of all other responsibilities and duties. Recent major governance failures at some of the major banks and NBFC are illustrative.
The performance, behaviour, attitudes, Key Responsibility Areas (KRAs) of all the Non- Executive directors shall be appraised annually both by the board and by independent agencies and their continuance or otherwise may be decided by BBB.
Accountability of the Board
Boards may not be accountable for each and every credit decision unless there is malfeasance. But the massive build up of NPAs over these years, is a reflection of major fault lines in business strategy, risk management strategy, risk appetite articulation, capital management etc. These strategic and tactical issues are fundamental elements of board oversight.
Role of DFS
The need for Department of Financial Services cannot be questioned. As the owner of different types of financial institutions, government needs a set up to look at their performance. In a sense, the relationship between banks and DFS is the same as that between the departments of government and the public sector units related to that department.
In the literature, the ‘arm’s length’ relationship has been talked about.
But there is no clear definition of the term. DFS should only issue broad policy guidelines and should refrain from issuing borrower specific advisories either formal or informal. Unless this principle is adhered to in letter and spirit, public sector banks cannot be held responsible for their performance.
The government’s decision to set up a specialised Development Finance Institution is a welcome move. But one DFI will not be able to cater to the needs of the entire sector.
As commercial bankers learnt much to their chagrin, that probability of default and loss given default are very high in project finance. This has been a near universal phenomenon. So far as PSU banks are concerned, only a small number of major banks may be designated to participate in project finance of big entities.
The way forward
The key recommendations can be summarised as follows:
1. It cannot be business as usual. Lenders, supervisors and the government have their task cut out to minimise probability of default and loss given default particularly for large advances.
2. Banks need to revisit and reset their appraisal process and monitoring by probing more deeply the character, capacity and capital contribution by the borrowers on an ongoing basis. They need to upgrade their skills.
3. Regulators need to identify excesses in lending, including credit concentrations, well in time and intervene to moderate lending in exuberant times. Some well defined indicators like credit growth in relation to GDP etc may be put in place.
4. While forbearance cannot be avoided totally, a distinction needs to be made between cyclical and secular declines of industries. More safeguards are needed in granting forbearance in secular decline scenarios.
5. Boards need to play a better role in identifying and mitigating strategic risks and restrain exuberance.
6. Government as the owner needs to redefine its engagement with PSU bank managements and boards as recommended by several Committees. Customer Specific Advisories should be avoided. (Concluded)
Rangarajan is former Chairman, PMEAC, and former Governor, RBI, and Sambamurthy is former Director and CEO, IDRBT