From UPSC perspective, the following things are important :
Prelims level : NPA, IBC.
Mains level : Paper 3- Novel approach needed to deal with the bankruptcy problem.
As our attention now shifts to the revival of the economy, we have to take stock of the damage to the economy. As recently as 2008 we have faced a financial crisis, but this crisis is bigger in the scale and our fiscal health is weaker than it was at the time of the 2008 crisis. So, to deal with the situation we have to adopt a novel approach. What should be the approach? Read further to know.
From 2014 to Covid-19 in finance and banking
- TBS challenge: As far back as December 2014, the banking sector and infrastructure firms had come under financial stress, a problem that was termed the Twin Balance Sheet (TBS) challenge.
- By December 2019, the problem had spread to the NBFC and real estate sectors, raising the number of stressed balance sheets to four.
- Following the Covid-19 shock, the problem of stressed balance sheets will spread across the economy.
How bad is the damage likely to be?
- Reports suggest that around one-third of industrial and service firms have applied for moratoria on their bank loans.
- If only a quarter of these deferred loans eventually go bad, then the stock of non-performing assets (NPAs) would increase by Rs 5 lakh crore.
- Senior bank officials have been quoted as estimating that the stock of NPAs could increase by as much as Rs 9 lakh crore.
- In this case, we would be looking at NPAs of Rs 18 lakh crore, equivalent to around 18 per cent of current loans outstanding.
So, how is the situation different from 2008 financial crisis?
- At one level, the answer is simple: The shareholders of the financial institutions, which in most cases means the government.
- But this is where the ubiquity of the balance sheet problem comes in.
- When the TBS challenge first materialised, after the Global Financial Crisis of 2008-09, the government had a relatively strong balance sheet.
- Deficits were low, and the consolidated debt-GDP ratio, having fallen by 17 percentage points over the previous 7 years, stood at just over 60 per cent of GDP.
- So, fiscal room was available, allowing the government to recapitalise the PSU banks.
- This time, the government’s financial position will be quite different.
- Central and state government deficits and debts will increase dramatically this year.
- Revenues, already slowing, have been decimated by the Covid crisis, while expenditures have increased.
- Add in a slowly recovering economy, and it becomes clear that the fiscal position will remain weak for some considerable time.
- What are the options with the government? The government will want to pass the burden onto the corporate and household sectors, in the form of higher taxes, more arrears, and possibly higher inflation.
- But these sectors will resist, for they have financial problems of their own.
2 ways to minimise the size of the loss
- It will be tempting to delay recognising the problem, pushing it into the future, by allowing banks not to classify bad loans as NPAs, and barring them from taking defaulters to the IBC system.
- But this would be the wrong approach and there are two ways to minimise the loss.
- 1. Prevent bankruptcies from occurring.
- To do this, banks will need to identify the firms that are viable, and lend them the funds they need to tide them over the immediate crisis.
- But banks are reluctant to bear the risk of making such loans.
- So, the government might need to create a guarantee fund to support lending.
- 2. When firms default, resolve as quickly as possible
- Speed is necessary because the financial position of stressed firms tends to worsen over time.
- By definition, stressed firms have poor cash flows and can’t obtain much in the way of loans from banks.
- So, they don’t have enough money to fund their operations properly.
- Which means that over time their underlying business deteriorates, destroying the firms’ market value.
- While public attention focuses on the size of the NPAs, a much more important number is the recovery rate — the degree to which the banks can recover on these loans.
- And the only way to maximise the recovery rate is to sort out the bad loans speedily.
- The economy will reap an additional benefit since the resolved firms will be able to contribute to the recovery.
Consider the question “As the economy stares at the destruction caused by the pandemic certain novel measures to salvage the economy are necessary. In light of this statement suggest the measures that the government should take to avoid the NPA problem from mounting.”
A new approach is consequently needed. The immediate problems created by the crisis must be addressed, decisively and quickly. Then the attention will have to turn to address the pre-COVID legacy balance sheet problems.
Back2Basics: What is NPA?
- A non-performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days.
- Banks are required to classify NPAs further into Substandard, Doubtful and Loss assets.
- Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.
- Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.
- Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”