Non Performance of Non-Performing Assets - Banking Laws in India

Banking sector reforms in India has progressed promptly on aspects like interest rate deregulation, reduction in statutory reserve requirements, prudential norms for interest rates, asset classification, income recognition and provisioning. But it could not match the pace with which it was expected to do. The accomplishment of these norms at the execution stages without restructuring the banking sector as such is creating havoc. This research paper deals with the problem of having non-performing assets, the reasons for mounting of non-performing assets and the practices present in other countries for dealing with non-performing assets.

During pre-nationalization period and after independence, the banking sector remained in private hands Large industries who had their control in the management of the banks were utilizing major portion of financial resources of the banking system and as a result low priority was accorded to priority sectors. Government of India nationalized the banks to make them as an instrument of economic and social change and the mandate given to the banks was to expand their networks in rural areas and to give loans to priority sectors such as small scale industries, self-employed groups, agriculture and schemes involving women.

To a certain extent the banking sector has achieved this mandate. Lead Bank Scheme enabled the banking system to expand its network in a planned way and make available banking series to the large number of population and touch every strata of society by extending credit to their productive endeavours. This is evident from the fact that population per office of commercial bank has come down from 66,000 in the year 1969 to 11,000 in 2004. Similarly, share of advances of public sector banks to priority sector increased form 14.6% in 1969 to 44% of the net bank credit. The number of deposit accounts of the banking system increased from over 3 crores in 1969 to over 30 crores. Borrowed accounts increased from 2.50 lakhs to over 2.68 crores.

Difficulties with the non-performing assets:

1. Owners do not receive a market return on their capital. In the worst case, if the bank fails, owners lose their assets. In modern times, this may affect a broad pool of shareholders.

2. Depositors do not receive a market return on savings. In the worst case if the bank fails, depositors lose their assets or uninsured balance. Banks also redistribute losses to other borrowers by charging higher interest rates. Lower deposit rates and higher lending rates repress savings and financial markets, which hampers economic growth.

3. Non performing loans epitomize bad investment. They misallocate credit from good projects, which do not receive funding, to failed projects. Bad investment ends up in misallocation of capital and, by extension, labour and natural resources. The economy performs below its production potential.

4. Non performing loans may spill over the banking system and contract the money stock, which may lead to economic contraction. This spillover effect can channelize through illiquidity or bank insolvency; (a) when many borrowers fail to pay interest, banks may experience liquidity shortages. These shortages can jam payments across the country, (b) illiquidity constraints bank in paying depositors e.g. cashing their paychecks. Banking panic follows. A run on banks by depositors as part of the national money stock become inoperative. The money stock contracts and economic contraction follows (c) undercapitalized banks exceeds the banks capital base.

Lending by banks has been highly politicized. It is common knowledge that loans are given to various industrial houses not on commercial considerations and viability of project but on political considerations; some politician would ask the bank to extend the loan to a particular corporate and the bank would oblige. In normal circumstances banks, before extending any loan, would make a thorough study of the actual need of the party concerned, the prospects of the business in which it is engaged, its track record, the quality of management and so on. Since this is not looked into, many of the loans become NPAs.
The loans for the weaker sections of the society and the waiving of the loans to farmers are another dimension of the politicization of bank lending.
Most of the depositor's money has been frittered away by the banks at the instance of politicians, while the same depositors are being made to pay through taxes to cover the losses of the bank.

Comparative Study With Other Countries
I. China: (a) Causes: (i) The State Owned Enterprises(SOE's) believe that there the government will bail them out in case of trouble and so they continue to take high risks and have not really strived to achieve profitability and to improve operational efficiency. (ii) Political and social implications of restructuring big SOE's force the government to keep them afloat,(iii) Banks are reluctant to lend to the private enterprises because while an NPA of an SOE is financially undesirable, an NPA of a private enterprise is both financially and politically undesirable,(iv) Courts are not reliable enforcement vehicles.

(b) Measures: (i) Reducing risk by strengthening banks, raising disclosure standards and spearheading reforms of the SOE's by reducing their level of debt, (ii) Laws were passed allowing the creation of asset management companies, foreign equity participation in securitization and asset backed securitization, (iii) The government which bore the financial loss of debt 'discounting'. Debt/equity swaps were allowed in case a growth opportunity existed, (iv) Incentives like tax breaks, exemption from administration fees and clear cut asset evaluation norms were implemented. The AMCs have been using leases, transfers, restructuring, debt- for-equity swaps and asset securitization, among other methods, to dispose of non-performing loans

II. Korea: (a) Causes: (i) Protracted periods of interest rate control and selective credit
allocations gave rise to an inefficient distribution of funds,(ii) Lack of Monitoring ..... Banks relied on collaterals and guarantees in the allocation of credit, and little attention was paid to earnings performance and cash flows,
(b) Measurers: (i) The speedy containment of systemic risk and the domestic credit crunch problem with the injection of large public funds for bank recapitalization, (ii) Corporate Restructuring Vehicles (CRVs) and Debt/Equity Swaps were used to facilitate the resolution of bad loans, (iii) Creation of the Korea Asset Management Corporation (KAMCO) and a NPA fund to fund to finance the purchase of NPAs, (iv) Strengthening of Provision norms and loan classification standards based on forward-looking criteria (like future cash flows) were implemented; (v) The objective of the central bank was solely defined as maintaining price stability. The Financial Supervisory Commission (FSC) was created (1998) to ensure an effective supervisory system in line with universal banking practices.

III. Japan: (a) Causes: (i) Investments was made real estate at high prices during the boom. The recession caused prices to crash and turned a lot of these loans bad, (ii) Legal mechanisms to dispose bad loans were time consuming and expensive and NPAs remained on the balance sheet, (iii) Expansionary fiscal policy measures administered to stimulate the economy supported industrial sectors like construction and real estate, which may further exacerbated the problem, (iv) Weak corporate governance coupled with a no-bankruptcy doctrine, (v) Inadequate accounting systems.
(b) Measures: (i) Amendment of foreign exchange control law (l997) and the threat of suspension of banking business in case of failure to satisfy the capital adequacy ratio prescribed, (ii) Accounting standards – Major business groups established a private standard-setting vehicle for Japanese accounting standards (2001) in line with international standards, (iii) Government Support - The government's committed public funds to deal with banking sector weakness.

III. Pakistan: (a) Causes: (i) Culture of "zero equity" projects where there was minimal due diligence was done by banks in giving loans coupled with collusive lending and poor corporate governance, (ii) Poor entrepreneurship, (iii) Chronic over-capacity/lack of competitive advantage,(iv) Directed lending where the senior management of the public sector banks gave loans to political heavy weights/ military commanders.

(b) Measures: (i) The top management of the banks was changed and appointment of independent directors in the board of directors , (ii) aggressive settlements were done by banks with their defaulting borrowers at values well below the actual debt outstanding and/or the amount awarded through the court process ..... i.e., large haircuts/ write offs, (iii) setting up of Corporate and Industrial Restructuring Corporation (CIRC) to take over the non-performing loan portfolios of nationalized banks on certain agreed terms and conditions and issue government guaranteed bonds earning market rates of return,(iv) The Banking Companies (Recovery of Loans, Advances, Credits and Finances) Act, 1997 was introduced in February 1997. Special banking courts have been established under this Act to facilitate the recovery of non-performing loans and advances from defaulted

Conclusion
I would suggest 3 ways of solving this problem of NPAs. They are (i) recapitalization of banks with Government aid, (ii) disposal and write off of NPAs, (iii) increased regulation.

The author can be reached at: kundusubhashis@legalserviceindia.com / Print This Article

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