Life of Debt
‘If I owe you a pound, I have a problem; but if I owe you a million, the problem is yours!’
-John Maynard Keynes
Graffiti had set its tone loud and clear; just no one acknowledged it. The bad loan episode that recently gripped India’s banking sector certainly did not trigger overnight. The timing of this article also could not be better – the recent Vijay Mallya (now a proclaimed offender) fallout and its aftermath is one story that has been hitting the news headlines on one hand and Subrata Roy of Sahara Group who is out on interim bail (but; not released) also happens to be in news. So, why is the timing perfect, you may ask? In the former case, Mallya managed to escape prosecution in India by evading his homeland whilst the latter was arrested and this resulted in (and; continues to) disposal of his assets domestically within India as well as overseas.
Banks after all play a fiduciary role in acting as trustees or custodians in distribution of domestic currency. Mobilizing deposits is crucial and vital for any developing country. Domestic funds on one hand promote the economic growth by controlling flow of currency and paves way for development on the other. Banking institutions employ a great deal of infrastructure, man-power, time and strategies in mobilizing the deposits. Banks’ lend and invest based on deposits, reserves and borrowings.
The asset quality held by banks reflects the quantity of existing and potential credit risk associated with the loan and investment portfolios, other real properties owned, and other fixed or current assets, as well as off-balance sheet transactions. Critically deficient asset quality or credit administration process can be detrimental to banking business and can result in a severe negative effect on bank, its business, its performance indicators such as credit rating, liquidity, revenue generation, and operation and control of bank. Critically deficient asset quality results in accumulation of non-performing assets (the NPAs)
So, what are Non-Performing Assets really?
In a bank’s purview, all loans and advances that it issues to its borrowers are considered as assets as it results in revenue generation for bank by collecting interest. However, these institutions do not undertake a coherent due diligence and investigations to scrutinize the authenticity of the underlying collateral or the capability of the borrowers to repay their debts. In essence, the bank’s revenue stream, its standing and credit worthiness will be in jeopardy; should the debtors default in their payments.
The Indian parliament realizing that turning a blind eye won’t help decided and passed the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (the SARFAESI Act) with a view to safeguard the interests of the secured creditors against defaulting debtors. Section 2(1) (o) of the SARFAESI Act dealing with non-performing assets (an NPA) provides that ‘NPA is a loan which has been classified by a bank or financial institution as sub-standard, doubtful or loss asset’. Further, a circular released by the Reserve Bank of India (the RBI) in 2014 states that a loan can be classified as sub-standard, doubtful or loss asset if the debtor has not paid its interest within 90 (ninety) days from the due date. This means that a loan account would be categorized as an NPA if its interest remains due for more than 90 days.
Earlier, a secured creditor’s sole recourse to realize an unpaid loan was to initiate a suit in a court of law to execute the underlying collateral property. The creditors were at a comparatively weaker position in this scenario as the judicial process was lengthy and exorbitant. Therefore, the main objective of the SARFAESI Act was to curtail the delay in the process of adjudication by empowering secured creditors to realize the underlying collateral without instituting a suit. Section 13 of the SARFAESI Act provides that the secured creditor of an NPA could send a written notice to the borrower requiring him to repay all his liabilities. Subsequently, the secured creditor would be authorized to undertake any of the following measures without the intervention of the court if the borrower has failed to repay his liabilities within 60 (sixty) days from the date of notice:
· to acquire the possession and the right to transfer the secured asset of the borrower;
· to take over the management of the borrower’s business which is the underlying collateral of the secured loan;
· to appoint a person to manage the secured asset of the borrower;
· to send a written notice to any person who has acquired the secured asset from the borrower or from whom any money in due to the borrower.
The Muddle in the Financial Industry
The SARFAESI Act has provided for lucid provisions regarding the power of a secured creditor to acquire the collateral of an NPA. However, the detrimental competition in the financial sector has adversely transformed the de rigueur of banks in order to increase the net value of their assets. Hence, they provide loans and other credit facilities without conducting an efficacious due diligence process regarding the borrower and their secured assets. Banks and financial institutions line up in order to provide large corporations with immense amounts of loans as this would substantially increase the asset value of the former. These institutions issue immense amount of loans to corporate giants without conducting thorough appraisals on the authenticity of the borrower. Further, these institutions are forced to reduce the minimum collateral required for corporate debts due to the goodwill of the large corporations and the enormity of the value of these debts. Therefore, banks are lured into issuing loans without obtaining adequate tangible collateral securities on the same.
Further, banks and financial institutions do not inquire on the corporations’ strategy to administer and discharge the loans. This implies that the banks do not exercise any kind of control over the debts once they have been issued. Therefore, top executives of the borrowing corporations are at the liberty of diverting these loans to other unrelated businesses or for their personal benefits. The borrower corporations cite a lack in profits or unfriendly governmental policies when they fail to meet the due dates of payments. The infamous case of the forlorn Kingfisher Airlines manifested this drawback in the financial system of the country when its CMD, Vijay Mallya, used the finances of United Breweries Limited in order to fund the working of the airline company. Further, the corporate governance standards of the country are also defeated when top executives of corporate giants exercise ultra vires acts to appropriate the company’s debts in order to meet their own whims and fancies. This substantially increases the possibility of borrowing corporations to manipulate the loan amounts in order to finance other entities without the bank’s knowledge. However, banks do not have the necessary framework to scrutinize the loan applications based on the authenticity of the borrower and the underlying secured collateral. Hence, the borrowing corporations take undue advantage of the bank’s failure to effectively monitor the appropriation of the loan amounts before and after its disbursement.
Securitization: The Antidote?
Earlier, banks were the primary intermediaries of the financial sector of the country. However, other types of financial intermediaries came into existence with the introduction of various financial products that aided in stabilizing the financial industry. Banks and other financial institutions require excessive amounts of liquid cash in order facilitate their daily operations. However, the assets of these institutions are blocked in various assets such as loans, advances, overdrafts etc. Therefore, their debt equity ratio and capital requirement are adversely affected due to this blockage of funds. This impediment is eliminated by the application of financial products such as securitization which succours the financial institutions in obtaining funds by the sale of existing financial assets. In the primary stage, the financial assets of banks and other financial institutions are combined and transformed into marketable securities. Subsequently, these marketable securities are sold to third party investors in the form of bonds or collateralized debt obligations (CDOs). Therefore, securitization is the financial practice of converting the financial assets of banks and other financial institutions, into marketable securities in order to sell them to third party investors.
A major drawback in the Indian securitization market is the lack of a substantial legislation to exercise and administer the transactions regarding securitization as the country is a relatively new player the market. However, the RBI has issued guidelines regarding the governance of securitization since the banks and financial institutions are the key participants in this market. Further, the parliament introduced the Finance Act of 2016 with the primary objective of amending the taxation laws relating to the securitization market in order to strengthen and expand the same.
The SARFAESI Act has provided for the institution of securitization companies and asset reconstruction companies in order to facilitate the process of securitization in the country. These companies are permitted to acquire the right arising from loan assets of banks and other financial institutions for the purpose of selling them to other investors. Section 5 of the SARFAESI Act provides that securitization and reconstruction companies can acquire the financial assets of banks and other financial institutions by entering into an agreement with the latter or by issuing debentures, bonds or securities.
Prevention is Better than Cure
Banks and financial institutions in the country have been tormented due to the pressure of the amplifying number of loan defaults affecting their credibility and overall financial condition. Hence, these financial institutions should strive to develop an effective monitoring process in order to determine the actual credibility of the borrowers prior to issuing loans and advances. Banks should conduct scrupulous periodic surveys on its debtors in order to defeat plight of the dying banking industry in the country. Frequently, the borrowers provide the banks with unidentified and marginalized collaterals in order to obtain high value loans. Therefore, the risk of nonpayment by the borrowers could be narrowed by scrutinizing the veracity of the collaterals which are provided by the borrowers. The financial institutions should also overview the application of the funds post disbursement of the loans in order to corroborate that the funds are not utilized by the borrowers for any fraudulent or illegal purposes. In essence, these financial institutions should implement a streamlined appraisal process to contemplate the meticulous employment of the loan amounts. Spasmodic internal and external audits by banks and the RBI could aid in identifying the obscure NPAs in the books of accounts.
Banks and financial institutions should be urged to disclose their NPAs on a regular basis to ensure that the deliberate defaulters are not issued loans elsewhere. Substantial legislations to counter red-tapism in the industry should be enacted by the parliament as quintessential financial industry is the principal catalyst of a rapidly developing country. Therefore, it is essential to maintain utmost transparency to apprehend any corrupt or fraudulent activities in the industry.
Further, the RBI should endeavor to enforce effective regulations in order to elevate the transparency in the financial sector. The latter should take necessary precautionary measures to avoid another recession as it is the central regulator of the country’s financial and banking sector. A recent report that the RBI had submitted to the Supreme Court of India has caused widespread panic in the financial sector as it revealed the details regarding the extent of bad debts that were borne by the banks in the country. Further, the inefficiency of the authorities to curb the issue of the NPAs could result in a serious impediment in the banking sector. The sour truth is that such impediments are the cardinal reasons that crash the economy of a rapidly developing country.