Pre-emption best cure for ailing Indian banking system

The Indian banking system needs more pre-emptive and precautionary measures to gauge stressed assets in advance, which will let bankers act early or even entirely prevent their creation, a research report from India Ratings, said. 

The Indian banking system is bogged down with bad loans worth over Rs 6.68 lakh crore, a 98% jump in non-performing assets year-on-year, in the July - September quarter, according to a report in The Hindu.

The government, along with the Reserve Bank of India, have taken several steps, with schemes like the 'Scheme for Sustainable Structuring of Stressed Assets (S4A), to rein in the bad loans problem in the public and private sector banks. The central bank also recently reiterated its deadline of March 2017 to show its commitment to banks' books clean up exercise

In the India Ratings report, titled 'Indian Financial Markets - The Next Wave' by Chandrajit Banerjee, Director General, Confederation of Indian Industry and Rakesh Valecha, Senior Director and Head, Credit and Market Research, the authors said, "Over and above the corrective actions that need to be taken, systemic focus should also be on preventive and curative mechanisms that will be effective check-points in the event of imminent potential stress." A curative mechanism will enable the stakeholders to act early, it said. In fact, such measures may also lead to avoiding stress altogether, as both lenders and borrowers arrive at a common framework for monitoring exposure, the report said. 

For this, the report suggests extensive use of covenants or agreements between corporates and the banks, as one of the main measures. 

Covenants can act as early warnings or 'trip wires', the report said, that assist lenders to manage credit risk, permitting them to reassess the borrowers' ability to repay debt. 

According to the research conducted by the agency, the report said, "...the use of covenants in monitoring loan exposures can reduce stress and time to recovery. ... It could be used more effectively to avoid a repeat of the asset quality problems facing the Indian banking system."

It could cut the recovery time from organic cash flows by half from the current 19-24 years. India Ratings analysed 83 stressed corporates borrowers with a debt of Rs 5.1 trillion, and said that the debt recovery time in this case could have been brought down to half or, in certain cases, could have been avoided altogether, with the use of covenants.

Valecha said, "The system needs to revisit the role of covenants in lending practices; well-defined covenants with effective monitoring will help the creditors have a greater say in the working of borrowers, especially in a situation of deteriorating performance. 

Protecting the banks' interests 

Since creditors bear the downside risks, covenants help keep conflict of interests between the lender and the borrower, to a minimum, to ensure the former's interests remain protected. 

The report said that covenants could protect lenders from the detrimental actions of equity owners, preserve a bond's priority of claims, accelerate restructuring to preserve  or distribute value to creditors, and ring fence an entity from the operations of its larger group or parent as in the case of infrastructure projects. 

Monitoring the problem 

Exogenous problems have become more challenging for developing economies that the endogenous ones. In a scenario like this, the report said the job of the forecaster is even more difficult, but also necessitates the need for close monitoring to protect the interest of respective shareholders.

"A stronger monitoring and implementation of covenant breaches will aid not only the creditors but will also go a long way in protecting shareholder value," Valecha said. 

Banerjee said, "Stress in the banking sector needs speedy and effective resolution to maintain the resilience of the overall economy. Pre-emptive measures to contain the instances and extent of stressed assets will go a long way in building a healthy banking system.