What is Wrong in the Risk Management Process in Indian Banks?

The hard truth is that every loan has both a borrower and a lender. If the loan is inherently
bad, the lender is as much at fault as the borrower.

The literature on managing the “NPA” problems of Indian PSU Banks keeps growing, but the
“NPA” problem keeps growing even faster! In this discussion, somehow, the weak, archaic,
and anachronistic conceptual framework under which most commercial bank lending is
practised in India, and its associated processes, rarely find mention - other than exhortations
that banks should improve their risk management systems.

In a manufacturing organisation to have low levels of rejects not only should the technology
used be appropriate to the product being manufactured but also the quality control process
should monitor the level of bad parts being produced, not only at the end stage but throughout
the manufacturing process. Indications of larger than permitted number of rejects suggests that
manufacturing process needs to be re-tooled or fine-tuned.

For banks to have low levels of NPAs, their entire lending process from initial appraisal, to
detailed due diligence, to monitoring, to detection of incipient sickness, to recovery has to be
under control. In addition, the conceptual framework for lending should be in line with the
market requirements. Recurrent high NPA levels clearly indicates that debt capacities are being
overestimated by the appraisal process and the relevant monitoring parameters are not doing
their job. The responsibility for rectifying this rests squarely on the lender.

That the faulty conceptual framework for commercial bank lending is a major impediment in
making good quality lending is reflected not only in recurring bouts of high NPAs, but, inter
alia, also in; constant complaints by industry that credit decision making in banks is slow and
cumbersome, getting credit, especially by the MSME sector, is extremely difficult, involves
humongous amounts of paperwork, the extremely long appraisal notes, the low level of credit
as a percentage of GDP, the over-emphasis on availability of tangible collateral security, the
preference of making investments in SLR securities than in making loans and advances etc.
etc.

Modern joint stock banks in India evolved out of Calcutta Agency Houses which were trading
firms which undertook banking operations for the benefit of their constituents (Tannan’s
Banking Law and Practice in India, 18th Edition, page 11). Naturally, the methodology which
developed was geared for lending for trading in commodities. This is a natural outcome, since
the evolution of capital markets through the introduction and diffusion of financial innovations
is largely dependent on occupational specialisation of the financial intermediary (V V Bhatt
EPW May 1987).

The credit risk in such cases was substantially covered by the cash credit system and its
associated practices of stock statements, its verification and calculation of drawing power.
Moral hazard being eliminated by having goods under lock and key of the banker, and by
periodically inspecting stocks to ensure that they confirmed in terms of specified quantity and
quality. Adverse selection was controlled by keeping a margin over market value of security.
This was easy as long as valuation of the underlying assets was straightforward and simple.
This credit risk management framework starts breaking down if it is extended for lending to
sectors other than trading, such as, industry, services, or agriculture.

First, in a manufacturing concern it is difficult to identify and easily value the various
components of current assets. The more complex the manufacturing process, the more difficult
it is to value the underlying security. Moreover, work-in-process, which might be a large
component of the Current Assets may have little market value. Even otherwise, Sundry Debtors
which are the most easily and objectively valued component of Current Assets may become
uncollectable if the seller closes shop and buyers shift their business elsewhere.

This system breaks down completely while evaluating the borrowing capacity of borrowers
operating in the services sector – where most of the earning assets are intangible. Currently the
services sector contributes more than 55% of the country’s GDP while its borrowing levels
have been hovering around 30% of bank credit over the last few decades – and most of the
exposure is predicated against tangible collateral security.

Second, the holy methods of lending and “working capital assessment” laid down by Tandon,
Chore, Nayak Committee et al, and still being followed in various avatars are essentially credit
rationing devices. The background for setting up the Tandon Committee (1974) was the need
to curb the use of bank credit for hoarding of commodities in short supply. The mandate given
to them was for framing guidelines for commercial banks for follow-up and supervision of
bank credit for ensuring proper end use of funds.

Similarly, the mandate of the Chore Committee (1979) was to review the operation of the cash
credit system of lending, particularly with reference to the gap between the sanctioned credit
limits and the extent of their utilisation.

Under the Nayak Committee method of assessing working capital requirements, the working
capital requirement is to be assessed at 25% of the projected turnover to be shared between the
borrower and the bank, viz. borrower contributing 5% of the turnover as net working capital
(NWC) and the bank providing finance at a minimum of 20% of the turnover.

As would be readily apparent, the primary question as to whether the borrower has debt
servicing capacity, ie, whether the borrower is credit worthy and what is its debt servicing
capacity is glaringly conspicuous by its absence under all the three approaches. These methods
of lending were never designed or meant to be a credit risk management tool but were to be
credit rationing devices. The fact that credit rationing implied some kind of credit risk control
is only incidental.

Debt repayment capacity under methods of lending is predicated on underlying security rather
than cash generation or debt servicing capacity. This leads to the primacy of the Current Ratio,
while leaving estimation of, profitability, cash-flows, leverage and interest coverage ratios or
structuring the loan so as to entrap the cash flows, as distant after-thoughts. The possibility and
need for amortisation of working capital borrowings, including the ubiquitous large permanent
cash credit component, is wholly missing.
Fourth, methods of lending, such as MPBF, creates entitlements on the amount of borrowing.
What is lost sight of is the kind of risk involved, ie, it does not differentiate between equity vs
debt risk. As a result, many a time the credit exposure comprises both equity as well as debt
risk, while the pricing is wholly related to debt risk. It is natural that the overall portfolio is
sub-optimally priced. The fact that at times bank finance substitutes equity is acknowledged by
various authorities (e.g., Dr. C Rangarajan in the TTK Memorial Lecture, 11/11/1997; Dr.
Raghuram Rajan, Note to Parliamentary Estimates Committee on Bank NPAs dated
06/09/2018;).

Fifth, the comfort that entitlements of the amount of borrowing is covered by security (current
or fixed assets as the case may be) is misplaced. No bank can run its business on foreclosure
of security as the primary means of recovery, especially in India with its slow and cranky legal
processes. The transaction costs would be too high, especially since banks survive on high
leverage with thin operating margins. The predominant consideration of tangible security in
lending, not only limits the volume of good loans which can be made but also leads to low
recovery in case the loans go bad.

Sixth, there are fundamental contradictions in considering that working capital lending is
essentially short-term lending. Very few businesses can afford to repay all its working capital
borrowings and continue to operate as a going concern. The only exceptions are commodity
traders, especially those whose operations are highly seasonal. In practice the balance sheet of
most borrowing entities continuously contain fairly high levels of working capital debt. The
peculiarity of working capital is that it keeps changing form; from raw materials, to work-in-
process, to finished goods, to receivables, to cash – all of which is continuously supported by
the working capital debt.

Seventh, the dichotomy between working capital and term finance is artificial since most
borrowers need both to continue as a going concern, and only a going-concern can service its
debt. As such, the focus should be on the total debt servicing capacity of the borrowing entity.
If there was any truth that banks should only concentrate on working capital lending, there
should be low levels of NPAs in such exposures. Which is not the case.

The primary value the banker brings to the societal table is ability to evaluate and manage all
kinds of risks in the lending process. As such, the risk management processes in banks should
be able to handle all kinds of risk, including credit risk. This realisation is also conspicuous by
its absence. The view that the latest round of high NPAs resulted inter alia from falling
commodity prices (market risk) and exuberance in lending for infrastructure projects (asset
liability risk) is a reflection of lack of skills in handling such risks. Classifying it as a reason
for creation of NPAs from this perspective makes it sound more like an excuse.

Furthermore, if lending to infrastructure projects led to large asset liability mismatches for the
lending banks (an oft heard reason for high levels of NPAs in banks exposed to the
infrastructure sector) it should have first led such banks to breach their asset/liability prudential
norms. There is no mention of this ever having happened. So how it led to credit risk remains
a mystery especially considering creating and benefiting from maturity mismatch is one of the
reasons financial intermediaries evolved.
The main factor for non-evolution of viable and cogent lending mechanisms is the lack of
professionalism and break-down in governance in PSU banks, essentially due to the extremely
corrosive influence of the Department of Financial Services (DFS) in their functioning. While
the mandarins in DFS exercise large control rents they have effectively no equity stake. As
very succinctly put in by Stiglitz & Weiss, “The incentives for individuals lending out money
that is not their own to make such gifts (in return for other favors) has, in the absence of the
checks of the market place, proven irresistible in instance after instance.”(Banks as Social
Accountants and Screening Devices for the Allocation of Credit – Stiglitz & Weiss 1988).

The pathological effects of such control have been documented time and again starting with
the Note by Prof M Datta Chaudhury and Shri M R Shroff in the report of CFS (Narasimham
I), to the Nayak Committee Recommendations, and by Viral Acharya and Raghuram Rajan in
their paper, Indian Banks: A Time to Reform, wherein they have strongly recommended for
abolition of DFS. The end result of this hegemony of DFS is the slow but steady deterioration
in the levels of professionalism of our banks with all its negative consequences, including non-
evolution of workable processes to handle credit risk for the MSME sector.

A pernicious aspect of the control by DFS is specially reflected in their interference in transfers,
postings, and appointments, especially for senior level positions. There is no reason that DFS
had to issue a clarification wide Office Memo dated 13/01/2015 to the effect that, “Each
Bank/FI should have their own objective, well laid out transfer and posting rules which should
be followed strictly. No exception, should be made in such rules at the behest of any
recommendation given by anyone including anybody from the Ministry of Finance.”

The poor governance of PSU banks is reflected not only in the recurrence of high NPA levels
but also other aspects of their functioning – witness the steady and sharp decline in their market
share in all aspects over the last 30 years, ie, since competition arose in the form of new private
sector banks.

Most policy prescriptions on managing NPAs seem to be focused only on timely recognition
of NPAs and actions to be taken after the loan has gone bad or at the most likely to go bad.
There is very little discussion on how to make good loans. After all, prevention is better than
cure.

It is insanity in doing the same thing over and over again, and expecting different results.