The Big BAD LOANS of India

Aditya Gupta
11 min readJul 4, 2020
illustration: icons8

Every time I hear about a top industrialist flying to another country, I have this uncanny feeling that this person might be leaving a huge hole in India’s banking system. Sometimes, it is also surprising that our government realises about their fleeing only when the person is found on a foreign media channel, blissfully shopping in the upmarket streets of plush first-world capitals wearing a GUCCI, PRADA or just CHANELing their pride of duping Indian banks?

Somehow, all of it doesn’t add up, right? Their fleeing and callousness towards not repaying massive loans, banks overlooking their due diligence process before lending, the Indian Government’s lackadaisical attitude towards big guys taking banks for a ride and putting a dent in the banking sector while our political leaders take years to extradite them from their ‘getaway home country’ for committing financial offences!

While you keep pondering over the politics of the whole saga, I will look at how and where it all started — the Big Bad Loans Problem — and how it affects us and the economy.

A Brief History

The banking sector in India has been facing an age-old yet prevalent problem where it is dominated by government banks (also called public sector banks), which operate above a level-playing field, compared to private and foreign banks as they are backed by the Central government.

Public Sector Banks (PSBs) in India hold 2/3rd of the assets while private banks clock higher transactions. As Economist Ruchir Sharma says “this is choking the Indian banking sector as private banks will continue to lend while central banks still hold the majority of assets.”

What is the Bad Loans Problem?

Banks give loans and advances to borrowers. A loan consists of principal payment and interest. A loan is considered an asset for a bank because it earns interest on the loan. Now, when a borrower makes regular payments to the loan, it is considered a standard asset which results in profit for the bank. But, when the borrower has stopped making interest or principal repayments for more than 90 days, the bank considers it a Non-Performing Asset (NPA). This means that a bank has to bear the loss in its books because it has failed to generate income.

Usually, the percentage of NPAs in any bank should not cross 1–2% of their assets. However, in any bank across India, it is over 4–5%. For banks which have lent millions to big corporates and have written off their loans, the NPA rate could easily be over 8–9% or even more than 10%.

…So, how did this all start?

When did it all begin?

The origins of India’s bad loans problem go much further back in time, in the decisions taken during the mid-2000s. During that period, economies all over the world were booming, almost no country more than India, where GDP growth had surged to 9–10% per annum. For the first time in the country’s history, things were looking bright: corporate profitability was amongst the highest in the world, encouraging firms to hire labour aggressively, which in turn sent wages soaring.

India seemed to have finally “arrived,” blazing through its long-awaited path as a reward for the economic reforms of 1991 to become a resilient, modern and a competitive economy. The next step was obvious: To walk down the path traversed by China, with double-digit growth, hopefully!

This hope gave companies a high and they made big plans. Their projects were so huge that they made crores of investments in the infrastructure and related sectors: leather, iron and steel, electricity and gas supply, construction and telecommunication, etc, setting off the country’s economic boom, followed by a strongly financed credit boom. What this did to India’s GDP was astounding! With just four years, the investment-GDP ratio had soared by 11 percentage points, reaching over 38% by 2007–08. And, to top it off, the amount of non-food bank credit doubled between 2004 and 2009.

(Source: The Calm Investor)

This was just from the banks. There was more funding flowing from overseas where the capital inflows in the financial year 2007–08 reached almost 9% of GDP. While this period mounted up the debt of non-financial corporations to large proportions, it also reflected that companies did away with their conservative Debt Equity Ratios and took advantage of the opportunities in front of them.

Well, just as companies began showing a larger appetite for risk, things started to overturn. Costs soared way beyond budgeted levels as securing land and other clearance became time-consuming and challenging at the same time. Growth began tanking to half the estimated levels, revenues collapsed and to top off, financing costs escalated. And, the years of strong global growth before the global financial crisis were followed by a slowdown, which extended even to India.

Despite domestic demand within India keeping the economy fuelled enough, all the companies that borrowed domestically suffered a huge blow when the Reserve Bank of India (RBI) increased interest rates to tackle the growing inflation. And, for firms that borrowed from abroad, the rupee value depreciated against the dollar, dealing them a bigger blow.

Higher costs, lower revenues, greater financing costs — all squeezed corporate cash flow, quickly leading to debt-servicing problems, beginning around 2012–13. By 2015–16, this crisis deepened with internal and external factors such as a fall in global commodity prices leading to lower exports. This contributed to India’s Twin Balance Sheet (TBS) problem where the banking sector (which gives loans) and the Corporate Sector (that takes and repays loans) came under financial stress.

Not just a small amount of stress, but one of the highest degrees of stress in the world. At its current level, India’s NPA ratio is higher than any other major emerging market (with the exception of Russia), higher even than the peak levels seen in Korea during the East Asian crisis.

Ballooning corporate debts

In India, the strategy that banks employed to resolve growing NPAs was to allow time for the corporate wounds to heal. That is, companies sought financial accommodation from their creditors, asking for principal payments to be postponed, on the grounds that if the projects were given sufficient time, they would eventually become viable.

As aftermath, once these massive projects got delayed, the promoter had little equity left in the project and eventually lost interest. Ideally, projects need to be restructured at such times, with banks writing down bank debt that is uncollectable, and promoters bringing in more equity, under the threat that they would otherwise lose their project.

Unfortunately, bankers (due to multiple vested interests) couldn’t make the promoters pay. Instead, they just extended more loans to enable the promoter to pay interest and pretended it was performing. The promoter had no need to bring in equity, the banker did not have to restructure and recognize losses or declare the loan as an NPA and spoil his profitability and, the government had no need to infuse capital.

In reality though, because the loan was actually an NPA, the bank’s profitability was a farce, and the size of losses on its balance sheet were ballooning because no interest was actually coming in. Unless the project miraculously recovered on its own — and with only a few exceptions, no one was seriously trying to put it back on track — this was deceptive accounting.

With public sector banks re-lending to faulty promoters without proper project evaluation and due diligence being an outsourced process, this became a weakness in the system where undue influence could be used for approvals. Finally, too many loans were made to well-connected promoters who have a history of defaulting on their loans.

As of March 31st, 2018, provisional estimates of the RBI suggest that the total volume of gross NPAs in the economy stands at Rs 10.35 lakh-crore. About 85% of these NPAs are from loans and advances of public sector banks. The total loan write-offs between 2008 and 2018 stood at 7 lakh-crore, according to the RBI. Interestingly, a large chunk of these write-offs have happened only after 2014.

Wilful defaulters on the rise

Adding to this is a high fraud occurrence where nearly 10% of total loans are never paid back to banks, pushing them into losses. Recent years have also shown us frauds (or wilful defaulters) of high magnitude that have contributed to rising NPAs. Although the size of frauds relative to the total volume of NPAs is relatively small, these frauds have been increasing, and there have been no cases of high profile fraudsters being penalised yet.

Loan exposure to the top 20 borrowers has spiked about 24% from FY18 to FY19. If one browses through the list of India’s top 20 loan defaulters, they are the most notable names among India’s businesses.

But, why do banks still lend massive amounts?

Now, each one of us has a story of a friend or colleague not returning our money. But, knowing this, why do banks really lend such massive amounts? Here’s my analysis:

1. If banks lend money to people like us or maybe even to farmers (a few lakhs for home loans, agriculture loans or other loans), the interest earned is much lesser but it increases the number of customers, eventually leading to increase in bank’s income. Now, every bank is mandated to meet 40% priority sector lending. But, under due government’s pressure, banks are now forced to focus on corporate lending instead of meeting their social sector targets. In other words, all the income earned through miniature assets of the bank is given off as one big corporate loan.

2. The glamour around huge loan borrowers is too good to ignore.

Scenario 1: Consider this: If I and Mukesh Ambani walk into a bank. I’m there for a Rs. 50 lakh loan but Mr. Ambani wants a Rs. 1500 crore loan, wouldn’t the bank oblige? In fact, it will proudly proclaim that Mr. Ambani is their customer.

Scenario 2: If my loan is rejected, only I will be sad. But, if Mr. Ambani’s loan is rejected, there would be an uproar in the internal circles, eventually leading to a lot of optics. So, even that way, Ambani wins in getting that massive loan!

3. Loans taken for business are based on certain assumptions of the product, company reputation, product or its market. If I borrowed a huge loan as an infrastructure company during the BJP due to influence and eventually, Congress came to power, they would cancel my contracts and my business would run into losses. In such a case, my business doesn’t pay me back. So, as a businessman, I’m at loss and will not repay loans, showing losses or I may eventually shut shop.

(In much smaller loans or genuine cases where people have borrowed a few lakhs for their house construction, a loss of job could be a reason for not paying the EMIs.)

4. In some cases, corporations borrow huge loans but wilfully refuse to repay.

Scenario 1: Let’s take the case of Vijay Mallya. He invested money into his business. Then he understood he couldn’t run it alone and approached others to invest in the company once it was listed. Investors came in through the stock market. Eventually, the company ran into losses. Investors lost money and so did Mr. Mallya. But, the blame is put on him saying he knew of the losses much before. (Well, the truth is open to guesswork!)

Scenario 2: When a corporate has taken a big loan and its promoters or owners begin diverting these funds for their personal use or by creating suitcase companies, that is where wilful default comes into picture.

5. Well, with priority sector lending being mandatory for banks, as mentioned above, farmers and small businesses are given loans. Eventually, due to rains or some weather shock, the crop fails. That means farmers may not repay the installments. While most banks do not resort to auctioning lands or properties of farmers, eventually, farm loans get waived off by banks due to political party promises in the election year. What happens after? The Government doesn’t pump in the money for waiver as promised before the polls. So, as part of the end game, banks take a beating and NPAs rise.

How the bad loans problem affects us

The grotesque exercise of lending to big corporates is now being compensated by recapitalisation of banks through public funding. In other words, taxpayers are bailing out terminally-ill banks of India while corporates continue to dent them.

According to the International Monetary Fund, the vulnerability of the Indian banking system is extremely high. “Banking systems in Brazil, India, Korea and Turkey also have relatively high vulnerability-weighted exposures,” the Global Financial Stability Report of the IMF said.

A report on The Dimension of NPAs states that the Debt to Equity (DER) ratio of Public Limited Companies varied between 45.9% and 46.2%. This suggests that these companies are not overly relying on borrowed funds for their operation. The DER and ICR of Private Limited Companies also suggest that Private Limited Companies in India are not overleveraged and earning enough to serve their debt. However, there are certain industry groups which are overleveraged.

Except for a few sectors which exhibited high leverage, the rest of the corporate sector borrowings are under permissible level. Therefore, the assumption of a weak corporate balance sheet does not justify any loan default. In fact, this can be established from the fact that the volume of wilful default has gone up substantially in recent years.

This means that Debt service is becoming riskier with a deteriorating economy, though banks are still taking the risk of debt concentration, as India’s top 20 borrowers have managed to get about Rs 16 of every Rs 100 loan amount of the Indian banking system.

While the RBI is considering low-interest rates as an alternative measure, it will have repercussions of an economic downturn, experts warn. The IMF says “Low-interest rates are encouraging corporations of eight major countries — US, China, Japan, Germany, Britain, France, Italy and Spain — to take a level of debt that they may fail to repay even if a downturn half as severe as 2008 occurs.”

Should India follow the East Asian model?

Perhaps, the most important difference between India and other countries, however, was the way in which the financial system responded to the intense stress on corporations. In other countries, creditors would have triggered bankruptcies, forcing a sharp adjustment that would have brought down growth in the short-run (even as the reconfiguration of the economy improved long-run prospects).

In many ways, India’s path has resembled that of China, but, on a much smaller scale since India’s estimated bad loans are just 1/7th the amount assessed for China. Both countries provided generous amounts of bank financing to allow highly levered corporations to survive. And, in both countries this strategy has proved successful so far in allowing rapid growth to continue. But, this model is highly unsustainable as it can lead to a collapse of the banking system. Instead, the East Asian model could have a solution.

After the 1990s crisis, East Asian countries were able to resolve most of their large NPA cases within two years. One reason, of course, was that the East Asian countries were under much more pressure: they were in crisis, whereas India has continued to grow rapidly. Secondly, East Asia was able to clean up its problem debts so quickly because it had efficient mechanisms and good leadership.

India has been pursuing a decentralised approach under which individual banks have been taking restructuring decisions, but with constraints and distorted incentives. Added to this was a delay in the entire NPA resolution process which is mired in corruption, red tape and political interference. In contrast, East Asia adopted a centralised strategy, which allowed debt problems to be worked out quickly using the vehicle of public asset rehabilitation companies.

Perhaps, it is time for India to try the ‘East Asian model’ and wallow through the mountain of the bad debts into a cleaner system.

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Aditya Gupta

Building | Product, Growth & Business | Investments @Hustle Partners | 2x exit | Startups. Travel. Music. Curious. Learner.