Mentors Comment:

Economic Survey recently highlighted the issue of TBS in its publication and since then, it has been a topic of interest for economists and bureaucrats because of the implications it can have on India and its economy. The question demands the discussion on three broader level.

First discuss what is TBS. Simply discuss the TBS in the intro and discuss how banking sector and over leveraged corporate sector is part of the problem.

Then discuss, whether this problem of TBS will lead to an economic crisis. Its important because in the discussion about TBS in Eco Survey, it was shown that India is an exception given the scale of problem of TBS. Hence don’t fall in the trap of the language of the question! Mention how TBS could have been a bigger issue but because of the confidence of investors on Indian economy, we have been saved by the blushes of TBS. But let’s not be complacent and instead work for its redressal. You can quote the example of South Korea which faced the same issue in 90s.

In the last portion, the question is directly asking for the way forward. Provide the measure that can be taken to tackle TBS issue.

Model Answer:

Economic Survey has pointed out that India should worry about the Twin Balance Sheet Problem, now widely known as TBS problem. A balance sheet is a financial statement that summarises a company/institution’s assets, liabilities and shareholders equity at a specific point of a time. Twin Balance Sheet Problem (TBS) deals with two balance sheet problems. One with Indian companies and the other with Indian Banks.

Thus, TBS is two two-fold problem for Indian economy which deals with:

• Overleveraged companies: Debt accumulation on companies is very high and thus they are unable to pay interest payments on loans.
• 40% of corporate debt is owed by companies who are not earning enough to pay back their interest payments.
• In technical terms, this means that they have an interest coverage ratio less than 1.
• Bad-loan-encumbered-banks: Non Performing Assets (NPA) of the banks is 9% for the total banking system of India. It is as high as 12.1% for Public Sector Banks.
• As companies fail to pay back principal or interest, banks are also in trouble.

Reasons for this problem:

• Origin of TBS problem can be traced to the 2000s when the economy was on an upward trajectory.
• Non-food bank credit doubled and capital inflows in 2007-08 reached 9% of GDP.
• Due to such a boom in the economy, firms started taking risks and abandoned their conservative debt/equity ratios and leveraged themselves up to take advantage of the upcoming opportunities.
• But Global Financial Crisis of 2008 reduced growth rates and thus revenues from the investment.
• Projects that had been built around the assumption that growth would continue at double digit levels were suddenly confronted with growth rates half that level.
• Firms that borrowed domestically suffered when RBI increased interest rates to avoid inflation increasing financial costs.
• Environment and land clearances in infrastructure sector delayed the projects.
• Thus higher cost, lower revenues, greater financial costs-all squeezed corporate cash flow leading to NPAs in the banking sector.

Will this lead to an economic crisis?

• The problem has reached to this scale where it threatens the stability of the entire banking system.
• The RBI expects bad loans to rise to 10.2% of the total loans by mid 2018. Currently, bad loans amount to 9.6% of the total loans as of March 2017. And if stress levels increase, bad loans could even rise to 11.2% by late 2018.
• For an economy to grow, its banks have to be stable. Plus, its companies have to keep planning new investments and projects. Otherwise, there would be no growth.
• Currently, banks are not stable. Banks reported that the amount of bad loans exceeded the total interests they earned as ‘operating earnings’.
• This makes banks very risky. If depositors start withdrawing money, a bank could easily shut.
• At such times, banks start lowering the amount of money it lends. This means the new companies that want to execute new projects or investments would not have access to funding.
• Lower investments have been the key cause of India’s slow economic growth in the past decade.
• India’s bad loan problem is much bigger than the peak levels seen in Korea during the Asian crisis.
• Korea’s bad loans touched a peak of 8.9%, lower than India’s 9-12%. India’s bad loans have crossed more than Rs.8 Trillion.
• Normally, TBS leads to an economic crisis and recession follows it.
• With the failure of corporate sectors and run on banks, economic takes severe hit.
• High inflation, loss of income, unemployment, weaker banking sector and loss of demand from the economy are some of the effects of TBS if not checked in early stage.

But India has been an unique case in that sense.

• Despite the fact that the ratio of NPAs to gross loans in India today is higher than in South Korea at the peak of the East Asian crisis, economy is not that effected.
• Growth has slowed down to 7%, but in the light of TBS problem, it is quite good.
• There are three possible reasons for this. First, despite the high level of NPAs, there has been no banking crisis.
• Elsewhere, there would a failure of public confidence in banks and several banks would fail. The contraction in credit would result in a recession. There has been no banking crisis in India because the banks most affected are PSBs.
• Depositors have the confidence that the government will ensure safety of deposits. Investors in PSB bonds know that the government will ensure that the minimum capital needed is made available.
• Second, the additions to infrastructure that have happened like more roads, ports, power stations, airports, better telecommunications may have created headaches for investors and banks.
• At the macro-level, however, they have eased supply constraints and helped growth.
• Third, Indian banks did not respond to companies’ woes by forcing bankruptcy.
• This would have meant seizing assets and trying to liquidate them. In India, this is a time-consuming process and results in poor recovery.
• So, wherever there is hope of a turnaround, banks prefer to keep the firm afloat. They reckon that, once growth accelerates, the firm’s cash flows and debt servicing will improve.
• The consequences thus far have been surprisingly benign, given the magnitude of the bad loan problem.

Steps taken to address the problem of NPA or TBS

India had taken different steps to tackle the NPA or TBS problem. Insolvency and Bankruptcy code too was in the same direction.

5/25 Refinancing of Infrastructure Scheme

• Under this scheme, lenders were allowed to extend amortisation periods to 25 years with interest rates adjusted every 5 years, so as to match the funding period with the long gestation and productive life of these projects.
• The scheme thus aimed to improve the credit profile and liquidity position of borrowers, while allowing banks to treat these loans as standard in their balance sheets, reducing provisioning costs.

Private Asset Reconstruction Companies (ARCs)

• ARCs acquire NPAs from banks or financial institutions and try to resolve them.
• ARCs are a product of and derive their asset resolution powers from the SARFAESI Act.

The Strategic Debt Restructuring (SDR) scheme

• The SDR scheme was introduced, under which banks could take over firms that were unable to pay and sell them to new owners.

Asset Quality Review (AQR)

• The RBI emphasised AQR, to verify that banks were assessing loans in line with RBI loan classification rules. Any deviations from such rules were to be rectified.

The Scheme for Sustainable Structuring of Stressed Assets (S4A)

• An independent agency hired by the banks will decide on how much of the stressed debt of a company is sustainable.
• The rest (unsustainable) will be converted into equity and preference share.

Way Forward:

• TBS problem can be resolved by taking a four step path that involves – recognition, recapitalization, resolution and reform.
• There needs to be a readiness to confront the losses that have already occurred in the banking system, and accept the political consequences of dealing with the problem.
• Time is opportune to create a centralized agency called Public Sector Asset Rehabilitation Agency (PARA) akin to that of East Asia adopted during their crises period.
• The centralized agency in the form of PARA would allow debt problems to be worked out quickly as highlighted in Economic Survey.
• The PARA needs to follow commercial rather than political principles. To achieve this, it would need to be an independent agency, staffed by banking professionals. It would also need a clear mandate of maximizing recoveries within a specified, reasonably short time period.
• The third issue is pricing. If loans are transferred at inflated prices, banks would be transferring losses to the Rehabilitation Agency. As a result, private sector banks could not be allowed to participate – and then coordination issues would remain – while private capital would not want to invest in the Agency, since PARA would make losses.
• A rekindled optimism on structural reforms in the Indian economy, along with implementation of GST and diligent implementation of Bankruptcy Code will play supporting pillars.

The twin balance sheet problem is a serious drag on credit growth. The setting up of a centrally-assisted rehabilitation agency will help in taking difficult decisions which the public sector banks are unable to take. The past mechanisms of resolving this problem in the form of decentralized approach have failed. There is no point of delaying this problem because the delay is very costly for the economy as impaired banks are scaling back their credit while the stressed companies are cutting their investments. The centralised agency in the form of PARA would allow debt problems to be worked out quickly. The time has come for India to consider the same approach.