Financial percent of the total loans lent by

Financial stability means that the financial institutions of the country, be it in a standalone form or in collaboration are able to function without any disruptions, able to absorb the external shocks and at the same time reflect the internal shortcomings. After being hit by the financial crisis of 2007-08, large number of banks in developing and developed countries failed, affecting the economy’s financial situation. It was then the importance of financial stability was realized by the central banks and the need of capitalizing came into picture 1. But the major road block on the way of maintaining a healthy balance sheet of the financial and real sector is the Twin-Balance sheet problem. It is a problem of banks not able to recover their loan amount along with the leverage issue of the corporates. As on August 2017, the bad loans for the Indian banks crossed INR 8 lakhs crore 2, which is around 11 percent of the total loans lent by the banks. This is a major problem because an economy to grow, it needs a stable financial system. If the amount of bad loans given out by the banks exceeds the income earned from the interests, then people would start withdrawing their deposits from the banks with the fear of bank going into bankruptcy. This would in turn lead to banks giving lesser amount of loans for investments done by individuals or corporates either for a new business or for an expansion of the existing one. And this has been the main cause of slow economic growth of the Indian economy in the past.

The Reserve Bank of India along with the Supreme court has taken few steps to fight against the issue of Non-performing assets. In February 2014 3, Joint Lenders Forum (JLF) was introduced by RBI. The RBI asks the banks to make a dedicated group of all those banks who have given loan to a concerned borrower who failed to repay either the principal or the interest and is reported to CRILC as SMA-2. This should be done under a convener (lead bank) to make a corrective action plan (CAP) common to all the banks in the group. However, one of the drawback of this approach seems to be that a plan suggested by the lead bank may not be in the interest of banks with the smallest share in the group. In June 2015 3, RBI introduced strategic Debt restructuring (SDR) for the stressed assets. Under this, banks who have given loans to the defaulting borrower/company has the right to take up the stakes in the loan taken company or the borrower’s company so as to convert its full or part amount of bad debt into the equity shares. By doing this, banks have more control over the borrowing distressed company’s management, making it easier for them to recover the loans. SDR initiative can be taken by the JLF mentioned earlier but the main issue here was the difficulty in finding buyers of equity. In June 2016 3, RBI launched a Scheme of Sustainable Structuring of Stressed assets (S4A). This scheme focused on giving the rights to banks (lender) to take ownership of the equity of the stressed projects. It is mainly for the large debted projects with an aim to improve the cash flows to important sectors like infrastructure etc. The main difference between S4A and SDR is that in SDR, banks have the total control over the management whereas S4A allows the existing management to continue the operations while being the minority.

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In May 2016, Insolvency and Bankruptcy code was introduced by the parliament which will provide a uniform, comprehensive, transparent and a speedy process to the financial institutions encompassing all the individuals, companies and partnerships for early detection of probable stressed assets/NPAs. It aims to resolve the insolvency problem of the company in a limited time frame which is usually 180 days and extendable to maximum of 90 days under certain cases. When a borrowing firm is unable to repay the loan, the control of the firm is shifted from the shareholders to the Committee of creditors who then have 180 days to revive the defaulting company or               wind up its assets by liquidation. RBI has a list of 12 large accounts which has been identified as defaulters. Their combined unpaid debt is around INR 2 lakh crore 4.

Stress Testing

It is a methodology to study the exposure/vulnerability of the financial system during the times of shocks to check if the banks have enough capital. RBI made it mandatory for the financial institutions to carry out stress testing in accordance with the given guidelines from March 2008. According to Stress Tests given in the RBI report of December 2017, Gross NPA ratio may increase to 10.8% in March 2018 and to 11.1% in September 2018 5. Also, the Network Analysis states that the interconnectedness within the financial system has declined in the past 5-6 years and therefore, losses from the default of a financial institution have also declined. Globally, stress testing is being used to identify which components of the balance sheet are affected by the various kinds of risks like credit risk, liquidity risk and market risk. The results of stress testing of each bank help their stakeholders to know how the bank would overcome various crisis in future.

Global Perspective

According to the CARE ratings, India has been ranked fifth in terms of highest levels of Non-Performing assets and first among the BRICS nations with 9.85% of NPA ratio 6. There have been two implications of India having of the highest NPAs. First is that financial Institutions have lost a significant portion of their funds. Second is that the banks are now reluctant to lend to large scale projects and this is the reason of why the lending has shifted to retail sector. If this trend continues, the level of Investment would follow a declining path in future.

If we compare our NPAs with that of our neighboring county i.e. China, we could have huge amount of learnings from the steps taken by them. China’s NPAs were far more than India’s 15 years back but now they are less than that of India. This is because they followed more stricter norms and indulged into more of securitization. But International Monetary Fund has recently assessed China’s performance on financial sector and came up with three major risks 7.

·       China has taken up high corporate debt

·       Lending for risky assets has been moved from banks to other non-financial institutions like insurance sector

·       “Widespread implicit guarantees” in China has led investors to take advantage of it and are thus, intentionally taking risks.

The other route to increase the investment is through foreign route i.e. Foreign Direct Investment. Currently FDI of 74% is allowed in the banking system 8. Out of this 49% is through the automatic route where there is no requirement of government or reserve bank of India’s approval. This increases the ease of doing the business and hence the foreign exchange position of India. FDI helps in increasing the formation of capital as there is direct investment either in the existing business or in a completely new business.

Securitization

Efficient financial market is the market where the prices of the assets truly tells the available information. The higher the transparency in the system, more efficient is the market. One of the major tool used by the financial companies to raise the funds while minimizing the risk is through securitization. It is the process of consolidating/pooling various kinds of financial debts/assets by the issuer and then selling related cash flows in different tiers to other investors. This process helps the issuer to remove the unwanted assets/debts from their balance sheet and hence improve their solvency power. Central bank asks the banks to lend a particular portion of their total lending to the priority sectors like agriculture, small and medium sized enterprises. This has led to increase in investments in securitization by the financial institutions. In turn, banks are benefited with higher credit ratings.

Recommendations

In order to improve the financial stability of the Indian financial system it is important for the government and the central bank to strengthen the financial institutions and making the system more transparent. Banks should be recapitalized so as to cover their NPAs and stricter norms should be laid down by the Reserve bank of India for distribution of loans either to the corporates or to the individuals.

The assets should be recognized at their fair value. This would help in bringing transparency in the financial market. More transparent the market is (Prices of the assets reflecting the majority of the information), more efficient would be the decision making by the banks in lending out funds and by depositors in trusting their banks.

More aggressive use of “Securitization” strategy would help to increase the investment in the economy reviving the financial sector. This revival should be diverted towards more of lending to the agriculture and Micro, small and medium enterprises as this sector is the one lagging behind the most.