India changes banking regulations to target non-performing loans

India’s government has announced a change to the Banking Regulation Act to allow the Reserve Bank of India (RBI) to give directions to banks to launch bankruptcy proceedings against defaulters. The move will allow banks to make use of the insolvency and bankruptcy code to speed up the process for resolving stressed assets. But the dual role of the RBI as the regulator and facilitator and how it will treat public sector entities objectively will be scrutinised.

Non-performing loans have risen sharply in India since 2014. Bad loans for public sector banks made up 11% of total loans for the year ending December 2016, ballooning to Rs 6 lakh crore ($93 billion). The statistic was 9.5% for 2015 and 5% in 2014. As a whole, the Indian banking system is facing a Rs 10 trillion stressed loan problem. The government’s notification of the change to the Banking Regulation Act is a part of the Insolvency and Bankruptcy Code 2016 provisions that allow the RBI to instruct banks to initiate actions to target defaulters.

More power to the RBI

The change in the law will give the RBI the power to direct banks to start insolvency proceedings against defaulters under the Insolvency and Bankruptcy Code in an attempt to resolve stressed assets. Banks can force defaulters to lose their ownership and voting rights in companies so that lenders can put in place measures to require the companies to turnaround within a specific period of time. Banks will also be able to restructure debts so that companies can pay them off more easily.

Arya Tripathy

“Historically, banks have been wary of recasting their loans, or approaching asset reconstruction, or initiating insolvency for fear of subsequent probes into their internal debt settlement procedures, management and financial health,” says Arya Tripathy, senior associate at PSA Legal. “With the new powers, RBI in its dual role of regulator and facilitator can shield distressed banks undergoing settlement of non-performing assets pursuant to RBI’s directions and supervision from any future investigation. This is likely to encourage banks for timely resolution of bad assets.”  

Though the RBI has issued guidelines on debt restructuring before, the banks regarded the actual process as their own internal affair, according to Tripathy: “While the Insolvency Code promises timely insolvency proceedings, there was no legal mandate on banks to resort to insolvency for their defaulters. Reluctance of banks to resolve bad debts for fear of scrutiny, combined with lack of rigorous penal sanctions in RBI floated restructuring schemes resulted in a crisis of non-performing assets (NPAs). This shook the confidence of depositors and an urgency was felt to cast RBI not only as a regulator directing steps for dealing with banks NPAs, but also facilitate implementation of those steps.”

“Banks are supportive of the ordinance and are hopeful that these measures by the RBI will assist in overcoming the problem of NPAs, the numbers of which look alarming,” says Kumar Singh, partner at Khaitan & Co. “Until now, there has been no accompanying action on part of banks to be able to deal with resolutions. The ordinance will allow RBI to issue instructions to the banks and banks are expecting that the pace of stressed assets resolution will pick up.”

“The powers of RBI to provide more haircuts to the banks will help to resolve issues because in large cases where banks are really finding it difficult to go ahead because of policy constraints, such types of measures are required whereby we can clean up our books and take a pragmatic view to go forward,” says Kumar Garg, executive director, Bank of Baroda, in an interview with The Economic Times.

Implementation challenges

Kumar Singh

While the RBI will gain new powers, implementing its objective will not be straightforward, as a large amount of coordination between the banks, RBI’s oversight committees and the RBI will be necessary. How defaulting entities in the public sector are treated will also be critical. “A pre-pack practice may evolve where the banks, prior to approaching the National Company Law Tribunal under the bankruptcy Code, will first approach the oversight committee to bless the decision being taken by the banks for a particular case,” says Singh. “Multiple oversight committee benches will have to be constituted by RBI, which may either be case specific or based on size of loans and sectors. One hopes that the powers vested with the RBI are used in a way to salvage viable enterprises by offering incentives to the banks to work out a time-bound resolution plan without any concern over subsequent regulatory scrutiny over such decisions.”

The ordinance is criticised for not providing detailed rationale, conflict of interest in RBI’s role as regulator and facilitator, and redundancy of vesting new rule-making powers with RBI when it already is empowered to issue directions to banks. “Initiating insolvency proceedings or imposing sanctions for non-settlement of stressed assets in case of public sector companies will likely question RBI’s independence, more so, when the government is allowed to issue directions to RBI for such matters,” says Tripathy. “In a similar vein, public sector banks where the proportion of NPAs is massive, RBI’s independence in taking actions under the ordinance will be susceptible to doubt, since the government will be the majority stakeholder and can lobby its way out.”

The changes to India’s banking laws is a notable step by the government in the country’s bad loans crisis. While the change will spur banks to use the bankruptcy code, what the implementation details will look like and whether entities will be treated objectively and consistently in the decision making process will be watched with interest.