The flip-side of RBI's "compromise settlement" formula for stressed asset

Ten days after Governor Shaktikanta Das red-flagged governance failures in public sector banks, the RBI has allowed all banking and other financial institutions to go for “compromise settlement” with loan defaulters classified as “wilful defaulters" or "frauds". In its circular, “Framework for Compromise Settlements and Technical Write-offs”, it proposes “to provide further impetus to resolution of stressed assets in the system as well as to rationalise and harmonise the instructions across all REs (regulated entities)” without citing any study or analysis to justify it.

While loan defaulters’ account marked as “fraud” need no explanation, those marked “wilful defaulters” are ones who have the ability to pay the loans but don’t. Both types of loan defaulters are invariably associated with money laundering, diversion of loans for purposes other than the sanctioned ones and other unacceptable or criminal activities. More often than not, these activities involve big corporate entities and their list has grown longer in recent years, as is the amount of write-offs as NPAs. The RBI has zealously guarded their identities in the name of protecting their business interests, rather than transparency and accountability in banking operations.

For better appreciation of what is in store with the “compromise settlement”, it is important to recall what the RBI Governor himself recently described as “innovative ways to conceal the real status of stressed loans”, while addressing the directors of PSBs on May 29, 2023 in Mumbai.

He listed the following “innovative ways” of concealment of stressed assets:

• “Bringing two lenders together to evergreen each other’s loans by sale and buyback of loans or debt instruments”;

• “Good borrowers being persuaded to enter into structured deals with a stressed borrower to conceal the stress”;

• “Use of Internal or Office accounts to adjust borrower's repayment obligations”;

• “Renewal of loans or disbursement of new/additional loans to the stressed borrower or related entities closer to the repayment date of the earlier loans”;

• “One method of evergreening, after being pointed out by the regulator, was replaced by another method”.

Das then asked: “Such practices beg the question as to whose interest such smart methods serve”.

Instead of answering the question and seeking tighter regulatory oversight and improvement in banking governance, Das merely advised banks and other financial institutions to ensure “conformity” with the policies and strategies laid down by their board and the RBI’s “guidelines” – knowing fully well that these had failed and “innovative ways” have been found to “conceal” stressed assets.

The RBI’s “compromise settlement”, issued on June 8, 2023, is the very anti-thesis of what should have been done. Essentially, the RBI circular says: (i) all regulated banks, NBFCs and financial institutions are now empowered (“delegation of powers for approval/sanction”) to “write off” loans marked as willful defaults and fraud and (ii) such debtors can be given “fresh” loans after a “cooling” period of 12 months or more (with the approval of their boards) of such compromise and write-offs.

Such powers are more likely to incentivise further banking frauds and willful defaults. Before explaining that, it may be pointed out that a write-off under a “compromise settlement” is different from normal write-offs of NPAs as in this case, there is no requirement to pay the outstanding amount and consequently, no recovery of the write-offs either. Such write-offs necessarily involve huge haircuts.

To understand why the RBI circular could be counter-productive, attention must be paid to four sets of critical data the RBI provides.

One is the rising write-offs. According to the RBI data, the NPA write-offs in SCBs (including that of willful defaulters) during FY05-FY14 was ₹63,000 crore – which skyrocketed to ₹12.3 lakh crore during FY15-FY22 (FY23 data is missing from the RBI’s annual report of 2022-23 released recently). This is 19.4 times higher. The spike during FY15-FY22 has a lot to do with exuberance in loan sanctions and evergreening during the previous UPA years but it also has a lot to do with deteriorating economic growth (which nosedived from 8.3% in FY17 to 3.9% in the pre-pandemic FY20 and -5.8% in FY21 before recovering to 9.1% in FY22). The “recovery” of NPAs written-off (not under ‘compromise settlement’ which is foregone) has been a mere 16.6% during FY18-FY22 – according to a Rajya Sabha reply of March 28, 2023.

Two, sudden spike in banking frauds, especially in FY18. It went up from Rs 34,993 crore during FY05-FY14 to Rs 5.89 lakh crore during FY15-FY23 – 16.8 times more. The number of fraud cases also went up by 1.4 times in comparison.

Three, dramatic rise in willful defaults. According to the Transunion Cibil registered with the RBI, there was a 38.5% or ₹94,000 crore, rise in willful defaults – from 12,911 accounts for ₹245,888 crore in December 2020 to 14,206 accounts for ₹285,583 crore in December 2021 to 15,778 for ₹340,570 crore in December 2022. This reflects the big “governance gap” – the gap between loan appraisals and risk management.

Four, high haircuts and low recovery through the Insolvency and Bankruptcy Code (IBC) of 2016. According to the regulator IBBI’s data up to March 2023, the recovery is mere 17.6% (combined for resolution and liquidation processes) – that is a haircut of 82.4%. Such low recovery points to the IBC’s many failures but the ones relevant in the present context are “asset stripping”, gaming of the system and diminishing political will (allowing the dilution of IBC and RBI’s regulatory powers) which have worked to the disadvantage of lenders (banks and other financial institutions) – as Fortune India explained in “Poor run for IBC continues. What ails it?”

All the four sets of data point to huge gaps in the stressed asset management and calls for more stringent norms, rather than more concessions and compromises.

Shifting the blame for banking failures

The blame for the NPA and banking crises of the recent past has been shifted to former RBI Governor Raghuram Rajan – the one who initiated the bank clean-up with his Asset Quality Review (AQR) in 2015. The Economic Survey of 2020-21 held him responsible for worsening the NPAs by stating that his AQR “led to a second round of lending distortions” causing further NPAs and the said AQR “could not bring out all the hidden bad assets in the bank books and led to an under-estimation of the capital requirements”. More recently, on June 9, 2023, Union Minister Rajeev Chandrasekhar said Rajan “wrecked the entire banking system and the financial sector”.

What such statements reflect is the unwillingness to take responsibility for bad governance in the banking system which led to multiple failures of banks and NBFCs in 2018. Essentially, these banks and NBFCs were hobbled by banking frauds – PMC Bank, Punjab National Bank, ICICI Bank, Yes Bank, Lakshmi Vilas Bank, IL&FS, HDIL, DHFL etc. Besides, many corporate tycoons involved with these banking frauds and others have fled the country and some loan defaulters have been found to have stashed their assets in tax havens while claiming bankruptcy.

True, bank balance sheets are a lot healthier and robust now but this has been achieved through (i) massive write-offs of NPAs (₹12.3 lakh crore) (ii) recapitalisation (₹3.12 lakh crore) and (iii) bailouts (Yes Bank and IL&FS, for example) – all with public money. It would be a mistake to consider the healthier and robust bank balance sheets a result of improved banking norms or regulatory oversight.

Add this loss of public money in write-offs, recapitalisation and bailouts to the gains that could have resulted from alternate and prudent deployment of it (economists call it “cost of opportunity lost”) and the magnitude of loss due to banking failures would be clear.