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Stressed Indian Banking Systems: Changing Dynamics And Way Forward

As per RBI, Gross bad loans at Indian banks may rise to 8.5 per cent of total assets by March 2017 from 7.6 per cent in March 2016 if the central bank goes ahead with a second round of asset quality review.

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As per RBI's Financial Stability Report (FSR) June 2016, the gross non-performing advances (GNPAs) rose sharply to 7.6 per cent of gross advances in March 2016 from 5.1 per cent in September 2015, largely reflecting re-classification of restructured advances to NPAs following an asset quality review (AQR). Risks to India's banking sector have increased since the publication of Reserve Bank of India (RBI)'s last Financial Stability Report (FSR) in December 2015, mainly due to a further deterioration in asset quality and low profitability. While the credit and deposit growth of Indian banks slowed significantly during 2015-16, their overall capital to risk-weighted assets ratio (CRAR) level increased between September 2015 and March 2016. The stressed loans of Indian banks are at Rs 5.8 trillion (approximately $85.9 billion) in March 2016.

Public sector banks (PSBs) continued to hold the highest level of stressed advances, with stressed assets to gross advances ratio at 14.5 per cent, whereas, both private sector banks (PVBs) and foreign banks (FBs), recorded stressed advances ratio at 4.5 per cent. Moreover, the profitability of Indian Banks declined significantly and the PSBs recorded losses during FY2015-16.

As per RBI, Gross bad loans at Indian banks may rise to 8.5 per cent of total assets by March 2017 from 7.6 per cent in March 2016 if the central bank goes ahead with a second round of asset quality review.

While the increase in stressed assets could be attributed, in part, to the economic slowdown and other macro factors, the following factors have contributed to the situation in no unequal measure:

" Lack of prudent lending and monitoring practices
" Financial mismanagement by the borrowers
" Capacity build up by borrowers and acquisitions by leveraging balance sheets

Certain sectors, specifically, infrastructure, iron & steel, textiles, aviation and mining have together contributed around 51 per cent of total stressed assets. A macro stress test of sectoral credit risk revealed that in a severe stress scenario, among the select seven sectors, iron and steel industry (which had the highest GNPA ratio at 30.4 per cent as of March 2016) could see its GNPA ratio moving up to 33.6 per cent by March 2017 followed by engineering (from 10.9 per cent to 15.9 per cent) and infrastructure (from 7.1 per cent to 13.4 per cent).

Share of large borrowers in total loans increased from 56.8 per cent to 58.0 per cent between September 2015 and March 2016. Their share in GNPAs also increased from 83.4 per cent to 86.4 percent during the same period. Advances to large borrowers classified as 'Special Mention Accounts' (SMA)-2 declined sharply by 40.5 per cent and restructured standard advances declined by 25.0 per cent between September 2015 and March 2016, simultaneously pushing up their GNPAs by 66.3 per cent, largely reflecting reclassification. Advances to large borrowers classified as SMA-1 (early signs of stress in asset quality), however, increased sharply by 35.1 per cent between September 2015 and March 2016.

Banks have preferred to address the problem of stressed loans through restructuring of debt under the aegis of corporate debt restructuring (CDR). In most cases, such a debt restructuring entailed reducing the interest rates, providing payment moratorium and extending the repayment period of a loan. Historically, sale to Asset Reconstruction Companies (ARCs) was a popular route among banks to address NPAs, but the poor returns from realization-linked Security Receipts (SRs) has dis-incentivized banks to use this route. Banks expect restructuring and sale of assets to ARCs (on a cash basis) to be the preferred routes to address NPAs. Large lenders with significant exposures to infrastructure and metal companies are showing more interest in resolving stress in these firms, rather than waiting for them to turn into bad loans and then just selling to ARCs.

As Indian banks are currently focusing on cleaning their balance sheets in the wake of the AQR, various measures taken by the Government to address the issues related to distressed industrial sectors are expected to help the process and improve the credit growth. The regulatory steps taken by the RBI are aimed at improving banks' ability to deal with stressed assets. While the proposed 'Large Exposures' framework will help in mitigating the risk posed to the banking system on account of large aggregate lending to a single corporate entity, the recent guidelines on a 'Scheme for Sustainable Structuring of Stressed Assets (S4A)' will help in putting real assets back on track through another avenue for reworking the financial structure of entities facing genuine difficulties, while providing upside to the lenders when the borrower turns around. The Insolvency and Bankruptcy Code (the Code), enacted in May 2016, provides for a clear, coherent and speedy process for early identification of financial distress and resolution of companies and limited liability entities if the underlying business is found to be viable. Under the provisions of the Code, insolvency resolution can be triggered at the first instance of default and the process of insolvency resolution has to be completed within stipulated time limit.

With a 11.5 per cent stressed asset book, Indian banks need prompt and systemic approaches to ensure recovery of their dues. Mutual trust between promoters, borrowers and external stakeholders is critical to the process.

RBI has given its approval to the idea of setting up a joint stressed asset fund led by banks to invest in debt ridden companies that do not have the ability to service their debt. Foreign distressed funds have shown interest in setting up distress asset investment platforms in association with Indian banks and NBFCs. Close to a dozen companies have applied to the Reserve Bank India (RBI) for licenses to start ARCs. These Stress Asset Funds (SAFs) backed ARCs will invest capital directly into businesses and/or acquire debt of such businesses and will focus on turnarounds rather than asset stripping and liquidation of the distressed firms.
ARCs and SAFs are betting heavily on the new bankruptcy law which will give them a greater leeway (including sale of whole or part of the company and change of management or promoter) to revive the distressed assets. These funds now consider this as a resolution business, then a recovery business. Resolution business is more of aggregating debt, fresh infusion of capital, identification of non-core assets, and bringing in a strategic partner and turnaround of the company. This requires a good mix of financing background, investment banking capabilities and an understanding of the equity market.

Globally, the distressed assets market began to emerge in the late 80s and early 90s in the US. In fact, most of the modern day private equity firms - KKR, WL Ross and JC Flower - owe their existence to early successes in the distressed assets business. By now, the US is also a major market for the ancillary industry around distressed assets, including trade in bonds of distressed companies and turnaround funds which buy completely broke companies, take over their managements, turn them around and then sell them. In Asia, the distress industry grew post the East Asian currency crisis in the late 90s. Early distress investors, such as Clearwater, Cerberus Capital, GE and Loan Star Funds, have made significant gains from such junk assets.

Debt restructuring is essential to the revival of stressed loans but an effective operational turnaround could be the difference between the success and failure of revival efforts.

Stressed businesses and their stakeholders (Banks, ARCs, SAFs) should acknowledge inefficiencies in their current business models in a timely manner and, in some situations, be willing to reinvent themselves completely. The blueprint to achieve an operational turnaround may appear simple - control cash, review pricing & renegotiate contracts, centralize procurement, reduce costs, consolidate footprint, rationalize unprofitable operations and sell off non-core assets, improve working capital and restructure the balance sheet. The challenge, however, is in the execution. The success of an operational turnaround hinges on:

1) The acknowledgement of the current situation by all stakeholders and commitment to the change needed.
2) Ability of the turnaround team on the ground.
3) An effective monitoring mechanism that ensures the long-term success of the turnaround plan.

An operational restructuring exercise can take anywhere from a few months to a year or more. To achieve sustainable change, the stakeholders should forget the quick fix and understand that operational restructuring is a time and resource-intensive exercise that is critical to secure the future of a troubled business.

Seeking assistance from external advisors or bringing in interim managers, often called Restructuring and Turnaround Consultants (RTCs), is common practice in such situations in developed markets. Apart from bridging the trust deficit between the incumbent management and external stakeholders, the RTC can be a catalyst for innovation, bringing fresh perspectives and stimulating change.

Way Forward:
Similar to Chapter 11 in the US or the Enterprise Act in the UK, a formal 'rescue' mechanism should be legally available to stakeholders which would enable the turnaround of the business in India under the provisions of the Insolvency and Bankruptcy Code. With this mechanism, in case of highly distressed companies or grossly mismanaged companies, the lenders can intervene to appoint a new management and take steps to operationally revive the underlying business in a timely manner.

While the picture regarding the Indian stressed loan market is often painted to look grim, the time is ripe to take decisive action. All the stakeholders have evolved and understand the steps needed to revive stressed assets - which is possible if the stakeholders' incentives are aligned, there is regulatory certainty and the system is supportive.

Cedar believes that in the near term, with more lenders/ARCs willing to play a more active and timely role in the operational revival of stressed companies - this could create significant value for all stakeholders involved in the process.

What Cedar's R&T Practice offers:
Cedar advises lenders and large corporate on debt restructuring and turnaround. On the Turnaround Advisory, we collaborate with company management and serve in interim roles to stabilize financial and operational performance by developing and implementing comprehensive Turnaround plans. Cedar's involvement reassures creditors and investors, of the company's intention to address problems and maximize value.

Disclaimer: The views expressed in the article above are those of the authors' and do not necessarily represent or reflect the views of this publishing house. Unless otherwise noted, the author is writing in his/her personal capacity. They are not intended and should not be thought to represent official ideas, attitudes, or policies of any agency or institution.

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Prashant Dhuri

Prashant Dhuri is an Associate Partner at Cedar Management Consulting and is an expert in Restructuring Planning, Financial Turnaround, Distressed Assets Resolution through Restructuring (CDR/SDR/S4A), Recapitalization & Divestments, Takeover through ARCs/SAFs and Debt/Equity Syndication

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