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Banks need to recognise an NPA when it happens, says YH Malegam

YH Malegam, who could easily be called the country’s finest chartered accountant and foremost financial expert, in an interview to CNBC-TV18’s Latha Venkatesh opens up on why banks are still struggling with non-performing assets (NPA).

He also offers a number of solutions on how to fix the problem of bad loans

“I would suggest that they [banks] should concentrate more on cash flows. As far as possible they should lend in the form of loans rather than in the form of cash credits and overdrafts,” says the former president of the Institute of Chartered Accountants of India.

These are, however, only two of the five solutions he offers. Read on.

Below is the transcript of YH Malegam’s interview with CNBC-TV18’s Latha Venkatesh

Q: Let us start with the genesis of the bad loan problem. The banks repeatedly say that they are able to sanction loans but they are not able to recover loans when they know it is going bad because the legal system is in such a tangle. Over 2 crore cases pending and they have to go through several rounds of the Debts Recovery Tribunal (DRT) before going to the courts. So, is the legal system the biggest culprit?

A: I don’t think so. It is of course a contributory factor. In my own view if you look at bank loans which have got bad it is because of inadequacy at three points. There is inadequacy at the point at which you sanction the loan, there is inadequacy at the point when you are monitoring the loan and there is inadequacy when you take steps to make the recovery.

If you look at each of these three separately – unfortunately there is a tendency in this country to lend money against security. But when you lend against security it depends upon the nature of the security. For example if you have lend money against inventory which is going to be realised on the course of business that inventory will generate cash. If you lend money against a factory or fixed assets the only way in which it generates cash is out of the profits which it makes. Therefore you have to have a different approach as to when you are lending against current assets when you are lending against fixed assets.

I believe that too much attention is being paid to security and too little to two other factors which are important.

The first factor of course is the quality of the borrower. I don’t think banks are making adequate studies about the background of the borrower, his past record, his integrity etc. But more importantly they are not looking at the cash flows which will be generated by the asset. As you know, if you lend against fixed assets the only cash flows which are generated are out of the profits which are made less the working capital which is involved. So, for example, as a rating agency what we would look at normally is the debt servicing coverage ratio (DSCR). So, this DSCR is an important matter and so long as the DSCR is projected at a level of between above unity, and at say to 1.5 then you have adequate security.

Q: But banks often tell us that even if the covenant triggers a recovery, assuming there was a covenant they don’t go for the recovery because the borrower goes to the court and then they are stuck. So, often they are allowing the loan to be given more, evergreened perhaps, because recovery is such a problem, you don’t think so?

A: No, I would put it the other way. If there was a covenant, the borrower in fact would be conscious of the fact that there is a covenant which may trigger a recall and therefore he would be careful to see that the recovery is not triggered. So, he would be more concerned with the observants of the covenant.

The second problem which is being faced is that we bankers lend today partly as term loans but also as cash credits and overdrafts. You lend as a cash credit or as overdraft. If you were to lend more against a loan the borrower would know what is the date on which he has got to make the repayment. He would therefore take adequate precautions to ensure that he has the liquidity available to make those repayments and monitoring the loan becomes easier whereas when you have a cash credit facility which is normally secured by hypothecation of assets and not by physical custody, very often the security disappears before even the bank is aware of what is happening.

Q: Banks have been lending for 70 years and there is a fair degree of sophistication I would assume in the last two and half decades when most of them have become listed and still rules like debt servicing capability and covenants to trigger recovery are not in the clauses?

A: There is another factor which I suspect is there. The concept today is that a bank wants to lend to a group. So, in a sense, in effect, it is lending to an entity in the group but it thinks it is lending to the group. Now in a group there are different entities and owned by different composition of shareholders. So, there may be a common promoter but the other shareholder and particularly for listed companies there are outside shareholders. Now if one company gets into difficulty you cannot expect another company in the group to bail it out because the other shareholders are not involved. The position would be different.

Let us see what happened when Tata Finance had a problem. Tata Sons put in the money because Tata Sons didn’t have to rely upon outside shareholders. They were putting in their own money. And they put in the money to safeguard the reputation of the group. Now, the same thing doesn’t happen in other groups if the entities which are considered together are not entities which are wholly owned and that is another factor that too many bankers have been chasing too many groups to get a share of the pie not realising that legally these are separate entities and recovery would be very difficult.

Q: Bankers’ defence is that there is no penalty from the vigilance commissioner for inaction. There is a lot of penalty if you take a pro-active stance and say for Rs 100 you give me Rs 85 and we settle the loan that is penalised. However, if Rs 100 asset rots for inaction and you get only Rs 10 or Rs 1 in the end or nothing at all, you are not pulled up, you are not visiting the CBI or the CVC?

A: I don’t know about that. However, there is a committee called the Bank Fraud Advisory Committee. For six years I was a member of that committee and the objective of that committee was that when there was any action to be taken against senior management in a bank, let’s say the chairman or the executive director or the general manager, even before a preliminary enquiry could be made the CVC would refer that matter to this committee. In the committee we would look at that issue and say whether prima facie there is a case for an enquiry or not.

There again we would look at in the same fashion, we would say on the basis of information which is available with the bank manager or the chairman, is there a right decision taken or not. We don’t look at it on the basis of hindsight and say because things went wrong; therefore it was a wrong decision.

I don’t mind telling you that within the six and half years or so which I was on the committee, we looked at atleast about 50 odd cases. In 25 cases we said no action is needed and in all of those cases it was accepted by the CVC.

So, so long as this system functions I don’t see why there should be a problem.

Q: Lately apparently the problem is resolved after 2011 but there were executive directors (ED) of banks saying that up until probably 2010 or 2011, the opposition of an ED to a loan was not even recorded in the minutes because the chairman passed the minutes.

A: I think that is a question which affects all professionals. However with due respect I don’t think that, that can be a excuse, whether you are a professional, whether you are a independent director or you are an executive director, you can’t take shelter behind the fact that I said this and it was not recorded. You should resign if you think that or you put on record if it is not recorded. You can’t have it both ways.

Q: Three years ago the PJ Nayak Committee presented its recommendations and asked that the government’s stake in public sector banks be brought down to 49 percent and that will make it work like a company under the Companies Act. Will that make a seminal difference? Is that the big mistake we made, not putting public sector banks under Companies Act?

A: I don’t personally believe that, that will be sufficient. For example in the case of most companies which are run by industrialists, they don’t own 51 percent of the share capital. They may hold 30 percent of the share capital. So, it is not how much share capital you own but how much control you exercise.

In fact the other recommendation of the committee makes more sense to me, which is that today there is a direct link between the department of banking and the bank. If you create in between a holding company, then the ownership of the holding company is with the government. However the board of the holding company is made answerable for the performance of banks.

Therefore to that extent they can do many things. What I am saying is that there is a difference between a government as a shareholder and the extent to which a shareholder should exercise control.

In good corporate governance what is the role of the board? The role of the board is to direct and control, it is not to manage. Similarly the board is answerable to the shareholders. That is the concept which has to be brought in to the banks. The board of the bank is answerable to the government as a shareholder for the performance of the bank.

However the government has no right to direct the board in specific matters and even more so the board has no right to manage the bank.

Q: If you have to apportion blame for the current bad loan mess and the outcry against bad loans, I will give you four options like a multiple choice question, economic slowdown, political ownership of banks, the legal system and promoters with bad intent, who is most to blame?

A: I don’t think we can apportion blame to just one or the other. I would even add a fifth question which is that, why is it that we are saying that there are large number of NPAs, have they really been generated now? I think the answer is, that NPAs were there but to a large extent they were not identified. Because of our rather pro-active stance which the Reserve Bank of India (RBI) has taken in the last one or two years, more NPAs have been unearthed.

Q: Therefore whom do you hold responsible at all for this mess in the order of importance? Is it bad banking, is it promoters whose intentions have gone awry after seeing too much money, is it the legal system which is preventing people from recovering even after recognising a bad loan?

A: It is a little difficult to say which is more important than the other. It is a combination of all of these factors. At the root of it I think if you talk of bad banking, I think the root of it has been too many bankers chasing too few borrowers. Therefore, there has been a tendency virtually to line up to offer money and it is difficult for a borrower to resist that temptation.

Q: What should be the way forward especially for public sector banks?

A: As I said one is, I would suggest that they should concentrate more on cash flows. Number two, they should as far as possible have more lending in the form of loans rather than in the form of cash credits and overdrafts.

Number three, they should have covenants and agreements on the basis of which those covenants they can recall the loans if the covenants have not been met.

Number four, they should look a little more closely at the antecedent of the borrowers, their past history and so on.

The fifth factor I think where perhaps something more has to be done is action for recovery should be taken much earlier. In my own view, once you have an NPA which is where the loan repayment or the interest repayment is not made within 90 days, if that situation continues for a year the loan becomes a doubtful loan. It is at that point of time I think the board of the bank or a committee of the board should take a decision, should we continue to support the borrower or should we in fact offer this to an asset reconstruction company (ARC). If you delay that then the realisablity of that asset itself deteriorates.

Q: Let me come to the current situation. There is a huge public outcry from investigative agencies, politicians, courts against promoters as villains. Do you think this noise is not distinguishing failure from fraud. An airline company everywhere is a very difficult business. Are we blurring that?

A: I entirely agree with you. The first problem is that there is a tendency to say in hindsight because the losses occur therefore there is something wrong. In any business losses will occur. A banker has to take certain risk and as people often say so long as you have ensured that more than 50 percent of your decisions are right, you are okay. So, that is one part.

Where there are proved cases of diversion of funds where there are cases where someone has mismanaged an organisation, yes, but you must make a distinction between fraud, between inefficiency which is there and a situation where external factors are responsible. So, whether you look at the steel companies, power companies these are areas in which maybe there the promoters are not entirely at fault.

Q: Do you think the government as owner and competitor is complicating matters. For instance, Air India could have unlimited credit with BPCL, Air India offers cut throat rates because the fisc is going to fund them. They don’t have to be competitive. Government is not a competitive shareholder. They don’t have market discipline. That skews the competitive field?

A: I am not quite frankly aware of what is happening at the airline industry but my gut feeling is that just merely because of a competitive airfare other airlines are not adversely affected. After all we see other airline like Indigo and so on which do run very profitably.

Q: Finally, one important piece of advice as to how we get out of this rather unfortunate situation?

A: The only advice I can give is, number one; you must be honest enough to recognise whether you have a loss. Number two, that a loss does not disappear only because you don’t provide for it in your books. So, you recognise the fact that you have a loss, you provide for that loss, you clean up your balance sheet, you improve your systems and then go forward.