Bad Debts: Bane of Banking System

In the recent past, lot of noise is witnessed both in electronic and print media over PSBs and their mounting bad debts.  Mallya and his Kingfisher episode which has only added that much more fuel to the fire—suddenly raised the nation’s concerns about the simmering troubles in the banking system. This deep distress caused by bad loans is quite palpable from what the Governor of RBI has to say: “Corporate sector vulnerabilities and the impact of their weak balance sheets on the financial system need closer monitoring.” 

Essentially, it is the failure of the businesses to generate the anticipated cash flows that disables borrowers from servicing their debt.  And there could be multiple reasons for such failures:

• Lack of entrepreneurship in executing the project as envisaged;
• Undertaking ambitious projects sans demand for the output, that too with no matching owned-funds accruals to realize the projected sales; unanticipated liquidity crisis owing to either non-availability of owned-funds or hiccups in the release of loan by banks; or
• Blatant misuse of funds by the borrowers. Time also plays havoc with many projects, for ‘time-overruns’ are as tempestuous as ‘cost-overruns’, which again is defined by the borrowers;
• Downturn in the economic-cycle too often adversely impacts the realisation of anticipated cash flows;
• Even delay in obtaining regulatory approvals is known to derail projects, as is being witnessed in the recent past in case of many infra projects where land acquisition has become a problem; 
• There could also be instances where banks themselves might have unwittingly paved the way for bad loans: lack of matching skills among banks to evaluate multivariate projects might have allowed the embedded risks of the project to creep into banks’ balance sheets; Or,
• Banks may not exercise the requisite resilience in locating the incipient sickness well in time and initiate appropriate action to stem the rot eating the core. 

That said, we must, in the fitness of things, also examine the role of ‘character’ of all those involved in the creation of bad debts for, it is the character of an individual or a corporate that ultimately defines their fate—at least that is what the Mallya conundrum signifies. The impact of character of the borrowers reflects on bank’s credit portfolio in two ways: one, the un-reined greed of the company for profits leads to excessive borrowing with no matching expertise to manage the businesses, or borrowing for projects with tailor-made demand forecasts that lands a company in financial troubles, and two, borrowers deliberately defaulting in repaying the debt. 

To better appreciate the importance of character in sustaining the banking system, we need to understand the loan sanctioning mechanics: banking system lends capital based on the estimated cost of the project and its ability to generate such cash flows which enables the borrower to retain a certain percentage of profit to satisfy the shareholders, after, of course, servicing the debt—all based on the information known then. Secondly, lending is often secured by the assets created by loan plus, occasionally, the personal guarantee of the promoter- directors.This poses an obvious question: Why not collateral security? Now, the commonsensical answer is: What could be the matching collateral for a debt of, say, as in the case of Mallya, Rs. 6,000 cr?  And who could offer such matching collateral? That aside, banks need to lend monies/funds to earn interest so as to service depositors besides earning profit for the stakeholders.

This being the complexity of credit creation, what the banking system needs for its survival is: ‘character’—value-driven character of the borrowers. And the absence of which is what the much talked about Mallya’s case typifies: Mallya owes around Rs. 9,000 cr to PSBs, that he continues his lavish lifestyle while his lenders are running from pillar to post to recover crores of rupees lent to him and over it, one fine night the billionaire flies away from the country.

In the drone of high pitched discussions about who is at fault: banks or borrowers for the present impasse, what everyone is missing is: the urgent need for a legal system that delivers verdict in a finite time. In the absence of an effective bankruptcy system in the country, banks find it just next impossible to effectively negotiate with the erring borrowers and get the assets back in functional mode with the least loss of time. Simply put, such a legal code will make everyone behave rightly.

The need for such a system gets further accentuated if we accept the fact that bad debts, no matter how aggressively RBI might energise banks to clean up their balance sheets, say within the next 12 or 18 months, will remain as an eternal problem as ever. For, as banks sanction fresh loans, some are bound to go bad for known or unknown reasons and so only the inventors of accounting system have designed a ledger entry: “bad debts” and “provision for bad debts”. It is equally important here to remember that every bad debt doesn’t mean that the underlying borrower is of bad character for, there could be umpteen reasons, some of them might be genuine ones for an account to turn bad. It is very important that bankers make this difference while addressing the bad debts problem.

That being the reality of bad debts, we need to revisit ‘character of borrowers/the corporate culture of India Inc, which incidentally is well captured by Raghuram Rajan when he observed: “If you flaunt your birthday bashes even while owing the system a lot of money, it does seem to suggest the public that you don’t care. I think that is the wrong message to send... if you are in trouble, you should be cutting down your expenses....” And this certainly needs to be shunned by the corporates for, it is not the economics alone that matters in making a country investment worthy, but also its core fabric of credit culture. And when we talk of character, it is, of course, of all those involved: borrowers, bankers and leaders.