At noon today, the Finance Minister introduced a Bill in Parliament to address the issue of delayed debt recovery. The Bill amends four laws including the SARFAESI Act and the DRT Act, which are primarily used for recovery of outstanding loans. In this context, we examine the rise in NPAs in India and ways in which this may be dealt with.
I. An overview of Non-Performing Assets in India
Banks give loans and advances to borrowers which may be categorised as: (i) standard asset (any loan which has not defaulted in repayment) or (ii) non-performing asset (NPA), based on their performance. NPAs are loans and advances given by banks, on which the borrower has ceased to pay interest and principal repayments. In recent years, the gross NPAs of banks have increased from 2.3% of total loans in 2008 to 4.3% in 2015 (see Figure 1 alongside*). The increase in NPAs may be due to various reasons, including slow growth in domestic market and drop in prices of commodities in the global markets. In addition, exports of products such as steel, textiles, leather and gems have slowed down.[i] The increase in NPAs affects the credit market in the country. This is due to the impact that non-repayment of loans has on the cash flow of banks and the availability of funds with them.[ii] Additionally, a rising trend in NPAs may also make banks unwilling to lend. This could be because there are lesser chances of debt recovery due to prevailing market conditions.[iii] For example, banks may be unwilling to lend to the steel sector if companies in this sector are making losses and defaulting on current loans. There are various legislative mechanisms available with banks for debt recovery. These include: (i) Recovery of Debt Due to Banks and Financial Institutions Act, 1993 (DRT Act) and (ii) Securitisation and Reconstruction of Financial Assets and Security Interest Act, 2002 (SARFAESI Act). The Debt Recovery Tribunals established under DRT Act allow banks to recover outstanding loans. The SARFAESI Act allows a secured creditor to enforce his security interest without the intervention of courts or tribunals. In addition to these, there are voluntary mechanisms such as Corporate Debt Restructuring and Strategic Debt Restructuring, which These mechanisms allow banks to collectively restructure debt of borrowers (which includes changing repayment schedule of loans) and take over the management of a company.
II. Challenges and recommendations for reform
In recent years, several committees have given recommendations on NPAs. We discuss these below.
Action against defaulters: Wilful default refers to a situation where a borrower defaults on the repayment of a loan, despite having adequate resources. As of December 2015, the public sector banks had 7,686 wilful defaulters, which accounted for Rs 66,000 crore of outstanding loans.[iv] The Standing Committee of Finance, in February 2016, observed that 21% of the total NPAs of banks were from wilful defaulters. It recommended that the names of top 30 wilful defaulters of every bank be made public. It noted that making such information publicly available would act as a deterrent for others.
Asset Reconstruction Companies (ARCs): ARCs purchase stressed assets from banks, and try to recover them. The ARCs buy NPAs from banks at a discount and try to recover the money. The Standing Committee observed that the prolonged slowdown in the economy had made it difficult for ARCs to absorb NPAs. Therefore, it recommended that the RBI should allow banks to absorb their written-off assets in a staggered manner. This would help them in gradually restoring their balance sheets to normal health.
Improved recovery: The process of recovering outstanding loans is time consuming. This includes time taken to resolve insolvency, which is a situation where a borrower is unable to repay his outstanding debt. The inability to resolve insolvency is one of the factors that impacts NPAS, the credit market, and affects the flow of money in the country.[v] As of 2015, it took over four years to resolve insolvency in India. This was higher than other countries such as the UK (1 year) and USA (1.5 years). The Insolvency and Bankruptcy Code seeks to address this situation. The Code, which was passed by Lok Sabha on May 5, 2016, is currently pending in Rajya Sabha. It provides a 180-day period to resolve insolvency (which includes change in repayment schedule of loans to recover outstanding loans.) If insolvency is not resolved within this time period, the company will go in for liquidation of its assets, and the creditors will be repaid from these sale proceeds.
[i] ‘Non-Performing Assets of Financial Institutions’, 27th Report of the Department-related Standing Committee on Finance, http://22.214.171.124/lsscommittee/Finance/16_Finance_27.pdf. [ii] Bankruptcy Law Reforms Committee, November 2015, http://finmin.nic.in/reports/BLRCReportVol1_04112015.pdf. [iii] Volume 2, Economic Survey 2015-16, http://indiabudget.nic.in/es2015-16/echapter-vol2.pdf. [iv] Starred Question No. 17, Rajya Sabha, Answered on April 26, Ministry of Finance. [v] Report of the Bankruptcy Law Reforms Committee, Ministry of Finance, November 2015, http://finmin.nic.in/reports/BLRCReportVol1_04112015.pdf. *Source: ‘Non-Performing Assets of Financial Institutions’, 27th Report of the Department-related Standing Committee on Finance, http://126.96.36.199/lsscommittee/Finance/16_Finance_27.pdf; PRS.
Need for Urban Co-operative Banks
The history of UCBs in India can be traced to the 19th century when such societies were set up drawing inspiration from the success of the co-operative movement in Britain and the co-operative credit movement in Germany. Urban co-operative credit societies, were organised on a community basis to meet the consumption-oriented credit needs of their members. UCBs are primary cooperative banks in urban and semi-urban areas. They are co-operative societies that undertake banking business. Co-operative banks accept deposits from the public and lend to their members. Co-operative banks are different from other co-operatives as they mobilise resources for lending and investment from the wider public rather than only their members.
Concerns regarding the professionalism of urban cooperative banks gave rise to the view that they should be better regulated. Large cooperative banks with paid-up share capital and reserves of one lakh rupees were brought under the scope of the Banking Regulation Act, 1949 with effect from March 1, 1966. Prior to this, such banks were regulated under the scope of state-specific cooperative laws. The revised framework brought them under the ambit of supervision of the RBI. Till 1996, these banks could lend money only for non-agricultural purposes. However, this distinction does not apply today.
The Expert Committee noted that UCBs play a key role in financial inclusion. It further observed that the focus area for UCBs has traditionally been communities and localities including workplace groups. They play an important role in the delivery of last-mile credit, even more so for those sections of the population who are not integrated into the mainstream banking framework. UCBs primarily lend to wage earners, small entrepreneurs, and businesses in urban and semi-urban areas. UCBs can be more responsive than formal banking channels to the needs of the local people.
Over the years, concerns have been raised about non-professional management in UCBs and that this can lead to weaker governance and risk management in these entities. RBI has also taken regulatory action on several UCBs. For instance, in September 2019, RBI placed Punjab and Maharashtra Co-operative Bank under restrictions on allegations of serious underreporting of non-performing assets. The bank could not grant loans, make investments or accept deposits without prior approval from RBI. While these restrictions were originally put in place for six months, the time frame was extended several times and has now been extended till December 31, 2021. In addition, low capital base, poor credit management and diversion of funds have also been issues in the sector.
Shrinking share in the banking sector
There were 1,539 UCBs in the country as of March 31, 2020, with deposits worth Rs 5,01,180 crore and advances worth Rs 3,05,370 crore. Even though 94% of the entities in the banking sector were UCBs their market share in the banking sector has been low and declining and stands at around 3%. UCBs accounted for 3.24% of the deposits and 2.69% of the advances in the banking sector. The Committee noted that state-of-the-art technology adopted by new players, such as small finance banks and fintech entities, along with commercial banks can disrupt the niche customer segment of the UCBs.
Figure 1: Growth in deposits of UCBs (in Rs crore)
Figure 2: Growth in advances of UCBs (in Rs crore)
Burden of non-performing assets
UCBs had the highest net non-performing asset (NNPA) ratio (5.26%) and gross non-performing asset (GNPA) ratio (10.96%) across the banking sector as of March 2020. These levels correspond to around twice that of private sector banks, and around five times that of small finance banks. The Committee noted that, as of March 2020, UCBs have the lowest level of net interest margin (difference between interest earned and interest spent relative to total interest generating assets held by the bank) and negative return on assets and return on equity.
Figure 3: Asset quality across banks (in percentage)
Sources: Report of the Expert Committee on Urban Co-operative Banks; PRS.
Supervisory Action Framework (SAF): SAF envisages corrective action by UCB and/or supervisory action by RBI on breach of financial thresholds related to asset quality, profitability and level of capital as measured by Capital to Risk-weighted Asset Ratio (CRAR). The Committee recommended that SAF should consider only asset quality (based on net non-performing asset ratio) and CRAR with an emphasis on reducing the time spent by a UCB under SAF. The RBI should begin the mandatory resolution process including reconstruction or compulsory merger as soon as a UCB reaches the third stage under SAF (CRAR less than 4.5% and/or net non-performing asset ratio above 12%).
Constraints in raising capital
The Committee also observed that UCBs are constrained in raising capital which restricts their ability to expand the business. According to co-operative principles, share capital is to be issued and refunded only at face value. Thus, investment in UCBs is less attractive as it does not lead to an increase in its value. Also, the principle of one member, one vote means that an interested investor cannot acquire a controlling stake in UCBs. It was earlier recommended that UCBs should be allowed to issue fresh capital at a premium based on the net worth of the entity at the end of the preceding year.
Listing of securities: The Committee recommended making suitable amendments to the Banking Regulation Act, 1949 to enable RBI to notify certain securities issued by any co-operative bank or class of co-operative banks to be covered under the Securities Contracts (Regulation) Act, 1956 and the Securities and Exchange Board of India Act, 1992. This will enable their listing and trading on a recognised stock exchange. Until such amendments are made, the Committee recommended that banks can be allowed to have a system on their websites to buy/sell securities at book value subject to the condition that the bank should ensure that the prospective buyer is eligible to be admitted as a member.
Conflict between Banking Regulation Act, 1949 and co-operative laws
The fundamental difference between banking companies and co-operative banks is in the voting rights of shareholders. In banking companies, each share has a corresponding vote. But in the case of co-operative banks, each shareholder has only one vote irrespective of the number of shares held. Despite RBI being the regulator of the banking sector, the regulation of co-operative banks by RBI was restricted to functions related directly to banking. This gave rise to dual regulation with governance, audit, and winding-up related functions regulated by state governments and central government for single-state banks and multi-state banks, respectively.
2020 Amendments to the Banking Regulation Act: In September 2020, the Banking Regulation Act, 1949 was amended to increase RBI’s powers over the regulation of co-operative banks including qualifications of management of these banks and supersession of board of directors. The Committee noted that due to the amendment of the Act, certain conflicts have arisen with various co-operative laws. For instance, the Act allows co-operative banks to issue shares at a premium, but it is silent on their redemption. It noted that if any co-operative societies’ legislation provides for redemption of shares only at par, then, while a co-operative bank incorporated under that legislation can issue shares at a premium, it can redeem them only at par.
Note that on September 3, 2021, the Madhya Pradesh High Court stayed a circular released by the RBI on appointment of managing director/whole-time director in UCBs. The circular provided for eligibility and propriety criteria for the appointment of such personnel in UCBs. The petitioner, Mahanagar Nagrik Sahakari Bank Maryadit, argued that the service conditions of the managing director and chief executive officer of co-operative banks are governed by bye-laws framed under the M.P. State Cooperative Societies Act, 1960. The petition noted that co-operative as a subject falls under the state list and hence the power to legislate in the field of co-operative societies falls under the domain of the states and not the central government.
Over the years, several committees have looked at the feasibility to set up an Umbrella Organisation (UO) for UCBs. It is an apex body of federating UCBs. In 2011, an expert committee on licensing of new UCBs recommended that there should be two separate UOs for the sector. In June 2019, RBI granted an in-principle approval to National Federation of Urban Co-operative Banks and Credit Societies Ltd to set up a UO in the form of a non-deposit taking non-banking finance company. The UO is expected to provide information technology and financial support to its federating members along with value-added services linked to treasury, foreign exchange and international remittances. It is envisaged to provide scale through network to smaller UCBs. The report of the current Committee recommended that the minimum capital of the UO should be Rs 300 crore. Once stabilised, the UO can explore the possibility of becoming a universal bank. It can also take up the role of a self-regulatory organisation for its member UCBs. The Committee also suggested that the membership of the UO can be opened-up to both financial and non-financial co-operatives who can make contributions through share capital in the UO.
Comments on the report of the Expert Committee are invited until September 30, 2021.