The non-performing loan woes of public sector banks have been discussed threadbare for a while now. Private sector banks have not exactly covered themselves with glory on this front. The inspections of the Reserve Bank of India have revealed a significant divergence between their declared NPA’s and that determined to be non performing by RBI. The NPA figures in the banking industry which seems constantly on the upswing, have now crossed USD 100 billion, while total stressed loans could be twice this figure.
Do corporate loans turn bad overnight? The Relationship Management team is supposed to have an ear to the ground, being closest to the market. Many banks have independent credit monitoring teams which also look for signs of potential trouble. Large accounts have direct visibility at the CEO and board level. Yet we see the relentless onslaught of non-performing loans emasculating Indian banking.
Early warning signs
Banks have a treasure trove of data in their core banking and other systems on the conduct of accounts. One of the first signs of trouble is stressed cash flows of the corporate borrower. This usually manifests in the form of ad hoc requests for temporary overdrafts. A one off instance is understandable. But frequent over drawing in the account is a red flag.
The borrower could then request for additional working capital facilities to avoid the day to day hassle of over drawings in the account. While such a request could be genuine at times, more often than not, it is a warning sign to the bank management.
As things further deteriorate, there is delay though not necessarily outright default in meeting loan interest and principal installment obligations. Letters of credit favouring suppliers of raw material could start devolving. Cheques issued by the borrower return unpaid. Quarterly results start reflecting weak margins and stressed cash flows.
As the scenario worsens, the corporate borrower may stop routing its sales receivables through the bank for fear of the cash flows being seized for loan obligations. Decline in credit turnover in the account is an early warning sign which banks must look out for.
While operational issues are clearly discernible after the event, analyzing and anticipating changes in the industry scenario requires different skill sets. Dumping of steel from low cost producing countries, cancellation of coal blocks a critical raw material source due to judicial intervention, power purchase agreements not being signed or rescinded are some of the factors behind the larger NPA’s. Banks with huge exposure need to build in house industry expertise in segments where they plan to take huge exposure and for subsequent monitoring, rather than relying on consultants who do not have any bottom line, for appraising projects.
Banks in India, US and other geographies have put in place systems to identify corporate borrowers who exhibit incipient signs of stress. The Reserve Bank of India lists 40 early warning signs which would qualify for a borrower being placed under a red flag status. Banks would need to report such accounts to the Central Repository of Information on Large Credits (CRILC) set up by RBI. The status of such accounts needs to be reported to the CEO every month. Such accounts thenceforth receive senior management attention in the form of close reviews.
The risk rating of such accounts usually gets downgraded. Efforts are made to reduce exposure. An exit strategy is put in place. Once the account technically becomes a NPA, it is a common practice to transfer it from the sales/relationship management team to a specialized recovery team.
The OCC in the US
The Office of the Comptroller of Currency, which supervises national banks in the US, calls for early identification of credit weaknesses and adverse credit trends, as a precursor to successful loan workouts/recovery. The OCC seeks a credit culture at banks, and rating systems that encourages lenders and managers to identify problem loans in a timely manner.
Technology can play a role
While large corporate accounts need a more nuanced and subjective approach in flagging off stressed conditions, software can help in identifying small and medium accounts which exhibit early warning signs. The software can read data from a bank’s systems as well as from external sources to flag off such accounts.
The system fails
Despite having a wealth of data, systems and institutionalized mechanisms, the non-performing loan levels in India are an indication that corporate bankers rarely pay heed to early warning signs in a borrower’s account. Several reasons can be attributed to this failure.
Fear of pulling the plug: the account team may be wary of precipitating a crisis by calling back the loan prematurely. Taken to the extreme, this might tantamount to “extend and pretend” that all is fine, by kicking the can down the road as far as possible. Conversely, the client facing team could be apprehensive of losing business in what could otherwise be a genuine short term issue.
Corporate accounts are booked in a bank as part of a fairly drawn out wooing process, spear headed by the sales team, often with senior management in tow. It is not easy to admit failure and recall the loan when it appears to be heading for trouble. It is common to see the sales team pushing the credit approving authorities for additional facilities, citing “temporary” cash flow mismatches of the borrower instead of calling back the loan and instituting recovery process. The client facing team which generates revenue for the bank, having an upper hand over the “old men” in credit management, is not uncommon in commercial banking. The banking supervisor OCC in the US too, talks of commercial lenders being reluctant to transfer a credit to the recovery team even after a problem loan has been identified and deems senior management/board support essential for making sure than lenders surface loan problems at the earliest possible stage.
While working capital facilities may potentially be recoverable by way of the borrower making alternative arrangements, long term project finance is not readily amenable to such refinancing. Having lent to the project, the fate of the bank’s loan is often irrevocably linked to the success or failure of the project.
A gold plated project is doomed to fail, from the word go. Once the promoters have taken out their contribution manifold, the project/company becomes unviable, and is now the bank’s problem to solve.
Such defaulters have perfected time tested methods to take out funds from bank funded legal entities by diverting cash flows to related parties, failing to repatriate export proceeds with the foreign “buyer” being a shell company of the promoter, deliberately invoking bank guarantees issued for non-existent projects awarded by the promoter’s own related company, fraudulent/accommodation inland bill transactions under letters of credit issued to associate companies without an underlying trade transaction etc. In most cases, shell companies/related parties of the promoter are the commonly used vehicles to divert funds from the bank funded borrower to the coffers of the promoter. Early warning signs flash all over such accounts, but for reasons best known to them, corporate bankers ignore them until “the bird has flown”!
Indian banking has seen several such egregious cases with rarely any such corporate defaulter paying the price, despite the seemingly strong resolve of the current administration. This must be perplexing as well as vexing to the tax payer, whose funds are ultimately used to bail out ailing public sector banks through recapitalization. Perhaps, the Indian taxpayer can take some small comfort that it’s a global phenomenon, with no criminal prosecution of either CEO’s or errant bankers in the United States, in the aftermath of the 2008 crisis which almost brought down the financial system, requiring a mammoth government led bailout of Wall Street banks.