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As Viral Acharya, who was a deputy governor of the RBI, put it in a 2016 interview, once you have the name of the country ‘or a state’s name in the name of the bank, the depositor knows … implicitly that the bank is … very safe’.

This belief, among other things, led to banks not cleaning up their bad loans. As of March 2015, the bad loans of PSBs stood at Rs 2,78,468 crore. This clearly did not reflect the total amount of actual bad loans in the system.

Meanwhile, Raghuram G. Rajan had taken over as the governor of the RBI in September 2013. It was only towards late 2014 that he started talking about the fact that banks were not recognizing bad loans and how the corporates had taken the banks for a ride.

Rajan had at his disposal a small army of RBI inspectors. He asked these inspectors to look very carefully at the books of PSBs. The idea was to figure out how big the bad money hole was. The findings revealed a distressing picture of the state of Indian banks.

Many big loans were officially in good shape, but in reality had gone bad, with very slim chances of being repaid. At the same time, many industrial projects for which debt had been taken and which officially were supposed to be in good shape, actually weren’t. The debt taken for these projects was never likely to be repaid. As Rajan admitted: ‘I got a sense that the numbers were hiding a darker problem.

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The banks had taken recourse to the various restructuring schemes that were on offer.

If the banks recognized the bad loans on time, they would have to make provisions for it, i.e., set aside money to meet these losses. Once they did that, their profit would come down.

Given this, and the fact that the ‘banker horizon [was] excessively short until end of the CEO’s term’, no one wanted to get into the messy bit of recognizing bad loans. Also, the restructured loans were exempted from provisioning. This also had incentivized restructuring, rather than recognizing bad loans as bad loans.

All this came to an end once the RBI launched the innocuously titled Asset Quality Review in July 2015. This involved RBI inspectors working with banks and going through their books and identified loans ‘that were of concern, as well as loans that had potential weaknesses’.

The dirt that came out of this exercise was huge. As Rajan put it: ‘It was at least two or three times what I expected.’

This can clearly be seen in the bad loans number of PSBs. As mentioned earlier, it was at Rs 2,78,468 crore as of March 2015. It jumped to Rs 8,95,601 crore as of March 2018. For banks as a whole, the bad loans had jumped from Rs 3,22,926 crore as of March 2015 to Rs 10,36,187 crore as of March 2018. The total amount of bad money in the system crossed Rs 10 lakh crore.

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The first step towards solving a problem is recognizing that it exists. By forcing an Asset Quality Review on PSBs, the RBI did precisely that. With the benefit of hindsight, it can clearly be said that this exercise should have been initiated at least three to four years earlier. But the thing is that until Rajan took over, the RBI did not seem to understand the gravity of the situation, or perhaps it simply ignored it.

There is a simple reason why recognizing a bad loan on time makes sense. It’s good accounting. Bad loans usually remain on the balance sheet of a bank for four years. After that, they are recognized as a loss asset and written-off, (We shall deal with this in detail in Chapter 17.)

A bad loan remains a substandard asset for a year and a doubtful asset for three years. As the number of years of a bad loan increases, the provisioning carried out against the bad loan keeps increasing as well. By the end of four years, a 100 per cent provisioning has been made against the bad loan. Hence, the bank has set aside enough money over a period of four years to write-off the bad loan.

Now take a situation where a bank has Rs 1,000 crore of outstanding loans from a corporate. The corporate stops paying interest on the loan and it is then categorized as a bad loan. In the first year, when the bad loan is a substandard asset, Rs 150 crore (or 15 per cent of the outstanding loan amount) will be provisioned against the loan. If it continues to remain unrecovered in the second year, it will become a doubtful asset. Between the start of the second year and the end of the fourth, another Rs 850 crore will be provisioned against the loan. At the end of the fourth year, the bank would have set aside Rs 1,000 crore to set off the losses against the loan.

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If at the end of the fourth year too the loan remains unpaid, then the bank has set aside enough money to face losses on the loan, categorize it as a loss asset and write it off

Now imagine a situation where a bank postpones the recognition of the same Rs 1,000 crore loan as a bad loan. One fine day, after the RBI crackdown, the bank will have to recognize Rs 1,000 crore as a loss asset and write-off 100 per cent of the loan. In this situation, the bank wouldn’t have set aside Rs 1,000 crore as a provision against this loan. This Rs 1,000-crore loss would have to be recognized against the most recent profit or, if the bank is not making any profit, against the bank’s capital. In the earlier case, the provisioning happened gradually over a period of time. Here it happens all at once and, hence, hurt the bank more.

Other than being bad accounting, it shows that the bank was not prepared, which isn’t good in a business as sensitive as banking. As Rajan put it: ‘We can postpone the day of reckoning with regulatory forbearance. But unless conditions in the industry improve suddenly and dramatically, the bank balance sheets present a distorted picture of health, and the eventual hole becomes bigger.’ This is how things played out in case of Indian PSBs.

Therefore, recognizing a bad loan as a bad loan on time is about doing the right thing and, in the process, preventing the problem from becoming bigger in the future.

This excerpt from Bad Money by Vivek Kaul has been published with permission from HarperCollins.

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