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The both the lender (banks, particularly the

The recent Economic Survey of India published by The Department of Economic Affairs and Finance Ministry and the bi-annual Financial Stability Report published by the Reserve Bank of India have pointed out at the following issues affecting the banking and the corporate sector of India: 1.     The Twin Balance Sheet Problem 2.     Bank Frauds and Cyber threats   In this paper, we will we focusing on Twin Balance Sheet Problem   What exactly do we mean by twin balance sheet problem? The word ‘twin’ is used to refer to the balance sheet of both the lender (banks, particularly the Public Sector Banks) as well as that of the borrowers (corporates). Thus, it talks about the problem of the Indian economy in which both these sectors are under stress. This problem can be studied through two aspects: 1.     Over leveraged corporate sector 2.     Debt laden Banking sector   Let us study the two in detail:   Over Leveraged Corporate Sector: During the boom years, the companies borrowed a lot of money which they are now finding it difficult to pay due to the economic slowdown in the country. Essentially, the interest coverage ratio of the companies is far below 1 and this has two consequences: ·      Their debt is rising at an alarming rate ·      They are cutting back on investments ·      They are finding it difficult to repay back the loans taken from banks and this brings us to the issue of NPAs ·      NPAs- Non-Performing Assets are those assets that have stopped generating income for the banks. In the legal terms, an asset is classified as a non-performing asset if any payment (interest or installment) in regard to the loan advanced, is unpaid for a period exceeding 90 days.·      Debt laden Banking sector: The credit creating ability of the banks has been seriously hit in the light of current events due to the following reasons:o   Due to the rising amount of NPAs, banks have to creates larger provisions to provide for uncertainties (SLR and CRR) o   Increasing NPAs have hit the bottom line of the banks and thus their credit creating abilitiesWhy is it a cause of worry?Both the problems mentioned above have detrimental effect on the economy in the long run due to the following reasons:1.     It may lead to an economic slowdown in the country as corporate sector cuts back on its investments.2.     The credit flow in the country have be badly impacted as the banks’ credit creation ability goes down. Thus, the TBS is a threat to the stability of the Indian banking system in particular and also to the entire financial setup of the country. How did it originate in the first place? During the boom period of 2000s, the companies in India, borrowed heavily to invest in their future growth. Given the economic scenario of that time, the companies overestimated their future profits and this is where things went wrong. This overestimation of the profits, ended them up in a debt trap and their interest payment capacity (measured by interest coverage ratio) was hit significantly, forget about the principal repayment. This problem has only worsened over the years and it is expected to take a toll on the entire economy.   How bad is the problem? The Reserve Bank of India has warned that the problem of NPAs is only going to worse with time unless strict actions are taken and they yield results. It is estimated that the bad loan problem will top us to 10% by March 2018. The banks are now hesitant to lend loans due to fear of bad debts and this is not good for a developing economy like ours.   What is IBC? Insolvency and Bankruptcy code is a law that was introduced in 2016. The law was introduced to solve the issue of $150 billion bad loans in the banking sector. In India, the bankruptcy process takes on average 4.3 years as compared to 0.5-1.5 years in countries like UK, Finland, Singapore. The law aims to bring down the bankruptcy time period by defining clear cut set of rules and a limited time frame in which the process should be completed. The salient features of IBC are: ·      Both creditor and debtor can start the recovery process against each other under IBC ·      The insolvency exercise should be completed within 180 days. The deadline can be extended up to 270 days only if the creditors have no issue with the extension. ·      For companies having turnover of less than 1 crore the insolvency exercise must be complete within 180 days and can be extended by a maximum of 45 days. ·      Insolvency and bankruptcy board of India acts as a regulator and has 10 members from the finance ministry and RBI ·      The bank officials won’t be targeted in case the insolvency exercise fails.   Pitfalls of IBC ·      In case of small and medium sized firms, the buyers don’t show much of an interest. In most cases only the promoters show the interest in such firms but now the government has barred them from bidding unless the NPA’s are resolved ·      In the 12 big cases referred to National Companies Law Tribunal, the banks have ended up taking up cuts of at least 50%. Thus, the banks end up incurring huge losses   Thus, in most cases a major amount of the debt ends up in the banks books. In case the issue is not resolved in the stipulated time limit the asset goes for liquidation. In this case the losses of the banks are even greater. IBC has been designed for a scenario where there are multiple buyers interested in buying the asset and thus the bids are sufficiently high. But the banks are facing the situation where very few buyers are interested in buying the asset and they play a waiting game so that the banks end up taking the cuts and they are able to buy the NPA’s at a much lesser price.   Global Perspective: 2008 Financial Crisis: Lessons to be Learnt from History In 2008, USA- Large scale default on US Housing mortgages triggered the Financial crisis 2008 that witnessed the fall of major financial giants- Lehman Brothers, American International Group, Merrill Lynch among many others. The major cause of Financial crisis 2008 was the the deregulation of the financial industry. This deregulation allowed the banks to create various kind of securities (derivatives, asset backed securities) and to disburse loan to subprime borrowers. This deregulation costed the USA’s economy heavily and thus what the Indian economy can learn from this is- The central bank of the country should closely monitor the Financial health of the country and the willful defaulters should be dealt with much wariness. The lending standards must be raised and should not be compromised. What are the RBI and the government doing to resolve this issue? The following measures have been taken by up the GOI and RBI: ·      To correct the bank’s Balance Sheet: Bail in Bail out- Recapitalization of banks- Project Indradhanush PCA framework ·      To correct the corporate Balance Sheet: o   Insolvency and Bankruptcy code   What is the difference between bail in and bail out? Both are the measures taken to rescue the financial institution, however both differ in their approach. Bail in typically is a process under which the creditors and the depositors are forced to take a haircut on their lending i.e. accept part payment/ loss for their share of investment. Recently the Indian Overseas Bank announced that it will use its funds parked in the share premium account to write off bad loans. The bank will use Rs. 7650 crores of funds to settle bad debts of worth Rs. 6978.94 crores.    Bail out is typically a process under which the financial institution is rescued by an external party- usually the government that uses taxpayers’ money. This brings us to the topic of bank recapitalization by GOI.   What do we mean by bank recapitalization by GOI? Over the years, GOI has been infusing capital in the PSB on the basis on need. This capital infusion has been through the preferential allotment of the equity shares by the banks to the GOI (major stakeholder in PSBs). The picture below summarizes the capital infused over the past years The Department of Financial Services (DFS), an extended arm of the finance ministry decides the allocation of the funds on the basis of the following parameters: ·      The credit growth of the bank ·      The riskiness of the assets held ·      The capital generation capacity of the bank (sources other than the government sources) ·      Scrutiny of the internal accruals     Note: Following the discussions of the First Banking Reform Conclave, Mr. Arun Jaitley, in August 2015 announced the  policy INDRADHANUSH- (a policy that enlists the seven-fold banking reform agenda) under which Rs. 70,000 were to be infused to the banking sector for the much-needed revival over the three financial years sprawling from 2015-16 to 2018-19.   Note: What is underway? The GOI and the RBI are in advanced talks to infuse Rs. 2.11 trillion (nearly about 1.3% of India’s GDp) capital into PSBs. In the past, capital infusion has not been uncommon however this time, the banks will be put under scrutiny post receiving funds.   What is the PCA framework? All the banks that have received the capital support have been put under the PCA- Prompt Corrective Action framework. It was first introduced in 2002 however in 2017 it gained momentum and has been implemented strictly.   The PCA framework tracks the 3 major key areas of the banking: ·       Profitability ·       Capital ·       Asset Quality   The tracking is done with the help of the following tools: ·       Capital Adequacy Ratio ·       Leverage of the bank ·       Return on Assets ·       Ratio of capital to risk-weighted assets (CRAR) ·       Net non-performing assets as a percentage of loans The framework has laid down the following 3 risk thresholds: Threshold 1 or 2: Subject to restrictions on branch expansion, payment of dividends, compensation of senior management, remittance of profits etc. Threshold 3: Once a bank breaches the ‘risk threshold 3’ , it becomes a candidate for resolution via amalgamation, restructuring, or even winding up.     Note: By far, these efforts of the GOI and RBI have yielded minimal results and it is imperative for these two parties to take quick actions that can yield faster results as there is time bomb trickling that can explode the economy any time! Recommendations: The sustainability of the Indian banking sector is under question. Provided the rising amount of NPAs and the global economic slowdown, there is a threat to     the overall stability of the macro economy that might pull the economy down and bring us much below the current growth rate of 6-7%. In the light of these events and the learnings from the Global Financial Crisis 2008, the RBI and the GOI should come down heavily on the loan defaulters and should restructure the entire financial system of the country. There is an urgent need to ensure that there are minimal leakages in the economy and that all the financial institutions perform their duties with due diligence. 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