Economics Prelims cum Mains

Why haircuts matter in dealing with bad loans?

The News

  • A panel submitted a report on analysis of NPA (Non-Performing Assets) crisis and recommended haircut as an option for faster resolution of non-performing assets.


Assets and NPA crisis

Different types of assets

  • All advances given by banks are termed assets, as they generate income for the bank by way of interest or instalments. However, a loan turns bad if the interest or instalment remains unpaid even after the due date.
  • Non-performing assets (NPA):
    • According to a RBI circular, all advances where interest and/or instalment of principal remains due for more than 90 days, would be classified as a “NPA”.
    • Further, NPA are classified as sub-standard, doubtful and loss assets depends on further due dates.
  • Restructured assets:
    • So what banks do to avoid a loan becoming NPA is to restructure it. After consultation with the borrower they either lower the interest rate or increase the total time for repayment.
    • When the terms of the loan given are changed after the sanction, so as to save an asset from slipping to non performing category, it is called a restructured asset.
    • Doing so Banks keep their balance sheet clean in short-term through postponing the recovery measures but in the long term the same assets come up very heavily upon the balance sheet, assets quality and the profitability of the banks.
  • Written-off assets:
    • These are those assets which the bank or lender doesn’t count the money borrower owes to it.
    • The financial statement of the bank will indicate that the written off loans are compensated through some other way. There is no meaning that the borrower is pardoned or got exempted from payment.
  • Stressed Asset = NPA + Restructured Asset + Written-off assets.



NPA crisis

  • Post global financial crisis (2009), RBI and the government relaxed lending norms to stimulate the economy and allowed banks to lend more to projects as part of a counter-cyclical measure.
  • The government also allowed banks to ‘restructure’ project loans that were going into default by giving borrowers more time and more money. Loans of these troubled borrowers were classified as ‘restructured’ and not NPAs.
  • Ideally, NPA should be within 2% of total assets (loans) for banks. Bad loans beyond this level are difficult to manage as banks work with narrow margins and the interest spread they earn is not enough to make up for the losses from defaults.
  • For public sector banks it has reached crisis level with gross NPAs at 14.6% — almost three times the level of 4.9% for private banks.



Dealing with NPA – SARFAESI vs IBC:

  • Earlier under Securitisation and Reconstruction of Financial Assets and Enforcement of Securities Interest Act, 2002 (SARFAESI Act), lenders could sell assets but not businesses as a whole.
  • In 2017, the new insolvency and bankruptcy code (IBC) provided a resolution mechanism for bad loans, enabling companies to be sold. With a mechanism in place, RBI removed restructuring schemes, asking banks to come clean on bad loans.
  • As a result, provisions rose to Rs 3.2 lakh crore in FY18 from Rs 2 lakh crore in FY17, surpassing operating profits of banks.



NPA crisis – Private vs public banks:

  • One reason private and foreign banks have a lower level of NPAs is they have the flexibility to cut their losses by selling off assets in a bad loan for whatever it is worth.
  • In the case of public sector banks, selling a loan or a company for less than the outstanding loan was not feasible as it would trigger action by Central Vigilance Commission, Central Bureau of Investigation and Comptroller and Auditor General.
  • It is only now that the bankruptcy code provides a framework for selling assets at a discount to the loan amount (taking a haircut).


Haircut: A solution or problem?

What is haircut?

  • A haircut is the difference between the market value of an asset used as loan collateral and the amount of the loan. The amount of the haircut reflects the lender’s perceived risk of loss from the asset falling in value or being sold in a fire sale.


Haircut – A solution:

  • As IBC provides a framework to sell bad assets at discounted price, banks can approach a resolution professional who invite bids for the bankrupt business.
  • So borrowers unable to repay their dues face insolvency proceedings in the National Company Law Tribunal (NCLT). The difference between the best bid and the borrower’s total outstanding dues is the haircut.
  • Thus with haircut as a solution, banks can clean their balance sheet once for all but with haircut losses.


Haircut – A problem:

  • With haircut, banks will lose huge amount of money. According to CLSA, the top-32 NPAs facing action under the bankruptcy code account for Rs 4 lakh crore or 45% of total NPAs.
  • CLSA estimates the haircut on these loans are less than 60%. Banks must make provisions for at least half the loan amount in case of bankruptcy.


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