What happened on Friday?

The President of India approved an ordinance to enhance the Reserve Bank of India’s powers to resolve the bad loan problem. The new powers include:

authorising RBI to issue direction to any bank to initiate bankruptcy proceedings against a loan defaulter

permitting RBI to issue directions to banks for resolution of stressed assets

permitting RBI to set up committees to advise banks on resolution of stressed assets

Also Read: Ordinance Gives RBI Sweeping Powers For Bad Loan Resolution

What is the problem?

India’s banking system is currently sitting on over Rs 7 lakh crore in gross non-performing assets (NPAs). The total stressed assets are higher at close to Rs 10 lakh crore. The struggle to recover these loans has hurt banks’ ability to issue new ones, clogging the credit system in the economy.

Despite several RBI schemes the problem refuses to be resolved, sometimes because banks don’t want to take a loss on the loan, at other times because borrowers refuse to cooperate.

In order to fix this, the government has decided to give RBI specific powers to intervene and find solutions, either by deciding the loss banks should take on a loan or by forcing the borrower into bankruptcy proceedings.

Why did the government do this?

The government’s reasoning is that banks are scared to take losses on a loan due to two reasons:

they would be investigated by vigilance authorities

they would need fresh capital to recompense the loss

Let’s explain that.

Take for instance, a large steel company which owed a bank Rs 10,000 crore and was unable to repay much of it due to an economic downturn. The bank assesses its loss to be, say, 50 percent, that is, only Rs 5,000 crore is recoverable.



Now the bank is worried that if it takes that loss right now and the steel industry recovers in a year or two it may be accused of poor decision-making. This may be the mildest accusation. In some cases, banks may fear being accused of allowing the steel company’s billionaire promoter to get away by repaying only half the loan.





The bank’s other concern would be to find the additional capital to provide for the Rs 5,000 crore loss, especially public sector banks that depend on the government for fresh capital.

In order to help the bank make a speedy decision, and in some cases a brave one, the government has given RBI powers to intervene and direct banks and borrowers to take action.

Also Read: Empowering RBI To Clean Up The Bad Loan Mess. Will It Work?

How will this work?

The success of this solution is pinned on the many layers of decision-making it proposes in an effort to spread the liability.

Banks are now expected to have the help of a credit rating agency’s report on the viability of the loan, RBI’s guidelines that will prompt them to action (failing which penalties will apply) and oversight committees that will scrutinise the decision making for due process. That way the burden of deciding on a loan loss or a borrower bankruptcy will be shared by many entities, ensuring nobody can point a finger at just one.

The government hopes this will embolden banks and scare borrowers towards a resolution. And if that doesn’t work, RBI’s intervention will.

What about recapitalisation of banks?

Good question.

If this succeeds banks will take losses on loans and will need new capital. But the government isn’t quite ready to cough up more.

So it’s told banks that any further capitalisation will depend on whether banks divest non-core operations, shut loss making branches and take other such measures to improve performance.

That suggests that not all public sector banks will get more funds. Some are reading this as the government’s nudge towards more consolidation in the banking industry.

Also Read: PSU Banks Must Do Their Bit To Get Capital From Government, Jaitley Says

Will this succeed?

It’s too early to tell.

Some bankers say this will assist in speedy resolution of stressed assets and bad loans.

Critics wonder why RBI should get involved in commercial decisions of banks.

History shows that more committees are rarely the solution to any problem.

But then history doesn’t always repeat itself.

. Read more on Business by BloombergQuint.