Today's Editorial

14 April 2017

NPA valuation is key to bad bank


Source: By K Vaidya Nathan: The Financial Express


The truth of a proposition is independent of how many people believe it to be correct. Probably most, possibly all but a handful of PSU banks are dead banks walking—zombie banks kept from formal insolvency only because they are government-owned. According to the 2017 Economic Survey, public-sector banks are saddled with 80% of the non-performing assets in the country and their NPA ratio has reached 12%. If Basel norms are strictly applied, most PSU banks should be deemed severely under-capitalised and should become history like Lehman Brothers. They would, but for the fact that they are government-owned. Ironically, it is this very fact that stops these rickety zombies from becoming good banks.

The bad bank proposal put forward by RBI and the Public Sector Asset Rehabilitation Agency (PARA) idea suggested by the Chief Economic Advisor have been non-starters for the simple reason that they require the valuation of NPAs. Putting a value to a non-performing loan is easier said than done because its true value is at best a bad ‘guesstimate’, even on a hold-to-maturity basis. Given the nebulousness in measuring their value, it is possible for an unscrupulous banker to manipulate the valuation to the detriment of the bank. The flip-side to this is that, if a PSU banker grants large debt reduction even if she believes it is the right thing to do, she could attract the attention of the investigative agencies, as PSU bankers come under the purview of PoCA (Prevention of Corruption Act). Paradoxically, government ownership makes the well-intentioned PSU banker an existential worrywart who deliberately chooses to kick the NPA ‘can’ down the road.

This inability to find a lasting solution has its cost on the real economy. A huge overhang of NPAs that PSU banks currently have, acts like a tax on new lending. Banks are required by RBI under the Basel guidelines to have a minimum amount of regulatory capital. Since PSU banks have only so much amount of capital and are already sitting on a ginormous NPA stockpile, they choose to hoard capital and ration lending rather than engage in new lending to the economy. Credit off-take to the industry, as a result, is now among the lowest in the last couple of decades. The government does not have too much fiscal leeway to inject so much capital that it stops being a constraint for banks to do fresh lending. So, the NPA issue needs to be tackled head-on to support new lending activities that are so urgently needed.

Most PSU banks in India follow the standardised approach for capital allocation under Pillar-I of Basel regulations. Under this rudimentary approach, they are not required to calculate the mark-to-model value of a loan at any given point in time, something that most large global banks do under the advanced approach of Basel. As a result, there is no agreed methodology for marking-to-model NPAs either by the regulator or by banks that is tailored for credit risk in the Indian context. And coupled with the fear that a vigilance investigation may pop up like a malignant lump just before the bank official is about to retire, makes the PSU banker pretend not to notice the elephant sitting the room.

Unless there is an objective method, largely agreed upon by the regulators and the banks, this problem is likely to continue. And in procrastinating about coming up with an objective methodology for valuing NPAs, even if it is not perfect, policy-makers, regulators and even academics may be kicking the sticky ‘can’ down the road. Not dealing with the NPA valuation problem but putting a band-aid on it, and hoping that the structural cracks in the PSU balance-sheets would heal with time, is procrastination or at best, wishful thinking. Not addressing the problem today may mean that the PSU banks may have to deal with something even worse in the future.

There are largely two different approaches to tackling the NPA valuation problem. The first may be to appoint a committee or task it to an autonomous body such as the Banks Board Bureau. But who is to say that however esteemed the committee members might be, the members would have the ability to value NPAs or worse, wouldn’t do it without prejudice or favour. The second approach is for the regulator to come up with a methodology that is as objective and fair as possible, acknowledging the fact upfront that it is not going to be perfect. For instance, to mark-to-model loans of publicly traded companies, the KMV model can be used.

The model is used globally but is far from perfect. The best thing about an approach like this is it is difficult to game the method because it uses just three inputs to find the mark-to-model value—the stock price, the volatility of stock price and the leverage of the firm. All three inputs are publicly known and have no element of subjectivity. For privately-held firms, the regulator can come up with a data-driven algorithm that uses historical corporate defaults and their recovery values as training data to produce a data-driven decision rule to value current NPAs.

Such data-driven algorithms have been used to predict lot more random outcomes like an election or a baseball game with reasonable precision. Of course, such approaches are not perfect, but perfectionism is often cited as the mother of procrastination. And there would always be sceptics who would think that all the quant models are hogwash, but the truth of a proposition is independent of how many people believe it to be correct.