Slowdown in credit growth due to stress in PSBs and not because of high interest rates: Rajan

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Reserve Bank of India (RBI) Governor Dr Raghuram Rajan has blamed the slowdown in credit growth to stress in public sector banking (PSBs) and not because of high interest rates. "...what is required is a clean-up of the balance sheets of public sector banks, which is what is underway and needs to be taken to its logical conclusion," he said while speaking at an interactive meet in Bengaluru organised by ASSOCHAM.

There is a slowdown in lending by public sector banks compared with private sector banks in non-food credit growth, he said, adding, that the immediate conclusion one would draw is that perhaps it is the lack of bank capital that is affecting credit growth. Yet, if we look at personal loan growth, and specifically housing loans, PSB loan growth approaches private sector bank growth. The lack of capital therefore cannot be the culprit. Rather than an across-the-board shrinkage of public sector lending, there seems to be shrinkage in certain areas of high credit exposure, specifically in loans to industry and to small enterprises."

Rajan says that the "The more appropriate conclusion then is that PSBs were shrinking exposure to infrastructure and industry risk right from early 2014 because of mounting distress on their past loans. Private sector banks, many of which did not have these past exposures, were more willing to service the mounting demand from both their traditional borrowers, as well as some of those corporates denied by the PSBs. Given, however, that PSBs are much bigger than private sector banks, private sector banks cannot substitute fully for the slowdown in PSBs credit. We absolutely need to get PSBs back into lending to industry and infrastructure, else credit and growth will suffer as the economy picks up," the RBI governor added.

Talking about the high interest rates affecting credit growth, Dr Rajan, said, this is another argument made by those who do not look at the evidence – that the stress in the corporate world is because of high interest rates. He says, "Interest rates set by private banks are usually equal or higher than rates set by public sector banks. Yet their credit growth does not seem to have suffered. The logical conclusion therefore, must be that it is not the level of interest rates that is the problem. Instead, stress is because of the loans already on PSB balance sheets, and their unwillingness to lend more to those sectors to which they have high exposure."

According to the RBI Governor, there are two sources of distressed loans – the fundamentals of the borrower not being good, and the ability of the lender to collect being weak and both are at work in the current distress.

"A number of these loans were made in 2007-2008. Economic growth was strong and the possibilities limitless. It is at such times that banks make mistakes. They extrapolate past growth and performance to the future. So, they are willing to accept higher leverage in projects, and less promoter equity. Indeed, sometimes banks signed up to lend based on project reports by the promoter’s investment bank, without doing their own due diligence. One promoter told me about how he was pursued then by banks waving cheque books, asking him to name the amount he wanted. This is the historic phenomenon of irrational exuberance, common across countries at such a phase in the cycle," he said.

The problem is that growth does not always take place as expected. Strong demand projections for various projects were shown to be increasingly unrealistic as domestic demand slowed down. Moreover, a variety of governance problems coupled with the fear of investigation slowed down bureaucratic decision making in Delhi, and permissions for infrastructure projects became hard to get. Project cost overruns escalated for stalled projects and they became increasingly unable to service debt.

Dr Rajan said, "I am not saying that there was no malfeasance – the country’s investigative agencies are looking into some cases such as those where undue influence was used in getting loans, or where actual fraud has been committed by diverting funds out of a company, either through over-invoicing imports sourced via a promoter-owned subsidiary abroad or exporting to related shell companies abroad and then claiming they defaulted. I am saying that, typically, there were factors other than malfeasance at play, and a number of genuine committed entrepreneurs are in trouble, as are banks that made reasonable business decisions given what they knew then."

As per the RBI Governor, poor monitoring and collection are the source of lending distress. "The truth is, even sensible lending will entail default," he said, adding, "A banker who lends with the intent of never experiencing a default is probably over-conservative and will lend to too few projects, thus hurting growth. But sensible lending means careful assessment up front of project prospects, which I have argued may have been marred by irrational exuberance or excessive dependence on evaluations by others."

"Unfortunately, too many projects were left weakly monitored, even as costs increased. Banks may have expected the lead bank to exercise adequate due diligence, but this did not always happen. Moreover, as a project went into distress, private banks were sometimes more agile in securing their positions with additional collateral from the promoter, or getting repaid, even while public sector banks continued supporting projects with fresh loans," he added.
Talking about collection process by banks, Dr Rajan feels laws like SARFAESI that are intended to speed up secured debt collection has been prolonged and costly, especially when banks face large, well-connected promoters. "Knowing that banks would find it hard to collect, some promoters encouraged them to “double-up”, by expanding the scale of the project, even though the initial scale was unable to service debt. Of course, the unscrupulous among the promoters continued to divert money from the expanded lending, increasing the size of the problem on bank balance sheets."

"The inefficient loan recovery system then gives promoters tremendous power over lenders. Not only can they play one lender off against another by threatening to divert payments to the favoured bank, they can also refuse to pay unless the lender brings in more money, especially if the lender fears the loan becoming a non-performing asset (NPA). Sometimes promoters can offer miserly one-time settlements (OTS) knowing that the system will ensure the banks can collect even secured loans only after years. Effectively, loans in such a system become implicit equity, with a tough promoter enjoying the upside in good times, and forcing banks to absorb losses in bad times, even while he holds on to his equity," the RBI Governor said.

Dr Rajan also criticised the incentives built into PSB system, especially for recovery of loans. He said, "The short tenure of managers means they are unwilling to recognise losses immediately, and more willing to postpone them into the future for their successors to deal with. Such distorted incentives lead to over lending to or “ever-greening” unviable projects. Unfortunately, also, the taint of NPA immediately makes them reluctant to lend to a project even if it is viable, for fear that the investigative agencies will not buy their rationale for lending. The absence of sound and well documented loan evaluation and monitoring practices by banks makes such an outcome more likely. So, excessive lending to bad projects and too little lending to viable ones can coexist."

Regulators who want to clean up the banking system so that it can again start lending do face a dilemma, the RBI Governor said. "First, we want banks to recognize loan distress and disclose it, not paper over it by ever-greening unviable projects. Second, we want them to be realistic about the project’s cash generating capacity, and structure lending and repayment to match that. And third, we want them to continue lending to viable projects, even if they had to be restructured in the past and are NPAs," he added.

The new tools effectively created a resolution system that replicated an out-of-court bankruptcy. Banks now had the power to resolve distress, so RBI could push them to exercise these powers by requiring recognition. This is what the Asset Quality Review (AQR), completed in October 2015 and subsequently shared with banks, sought to accomplish.

He said, "There is a change in culture, and banks have been quite willing to get into the spirit of the AQR. Many have gone significantly beyond our indications in what they have cleaned up by the quarter ending March 2016. Of course, once the banks have properly classified a non-performing loan and provisioned against it, their incentive to evergreen or avoid writing down the debt to appropriate levels is diminished."

Sending stern message to wilful defaulters, the RBI Governor said, "Even while we make it easier for committed promoters to restructure when they experience bad luck or unforeseen problems, we should reduce the ability of the fraudster or the wilful defaulter, who can pay but simply is disinclined to do so, or the fraudster, to get away. This is why it is extremely important that banks do not use the new flexible schemes for promoters who habitually misuse the system (everyone knows who these are) or for fraudsters. The threat of labelling a promoter a wilful defaulter could be effective in the former case, and we have coordinated with SEBI to increase penalties for wilful defaulters. For fraudsters, quick and effective investigation by the investigative agencies is extremely important. We should send the message that no one can get away, and I am glad that the Prime Minister’s Office is pushing prosecution of large frauds. The RBI has set up a fraud monitoring cell to coordinate the early reporting of fraud cases to the investigative agencies. And for those who have diverted money out of their companies, especially into highly visible assets abroad, a stern message sent by bankers sitting together with investigative agencies should help send the message that the alternatives to repayment can be harsh."

"The cleaning up of bank balance sheets, and the restoration of credit growth are vital, related elements in the growth agenda. The government and the RBI are helping our public sector bankers in this difficult but critical task. I know the process is working, so PSBs will soon be set to finance the enormous needs of this economy once again," Dr Rajan concluded.