How can Indian banks face the looming disaster from failing restructured loans?

Here are 4 things banks and governments alike must do to address reduction in asset quality concerns.

Asian Banking and Finance asked BBVA and Standard & Poor's, and here's their detailed insights:

BBVA: Alicia Garcia Herrero, Chief Economist for Emerging Markets
Concerns over Indian banks’ asset quality have been growing over the last three years. RBI data suggests that stressed assets of Indian banks, which includes gross non-performing loans (NPLs) and restructured loans, jumped nearly 56% y/y to a record Rs 3.6 tn (USD 67 bn) during the fiscal year 2012 (year ending March 2012). As such, stressed assets accounted for 7.7% of total banking credit, up from 5.8% in the previous year.

Although broad based, asset quality deterioration has been particularly high amongst public sector banks as compared to private and foreign banks. Restructured loans have been significantly high across medium and large firms in the industries segment (9.34% of total sector loans in FY12) while priority sector, retail, micro and small enterprises and agriculture formed the bulk of non-performing assets. Industry-wise, the sensitive sectors include metals, power, textiles, engineering, chemicals and infrastructure, wherein banks’ exposure ranges from 15% to 20% of total loan book.

As per ratings agency CRISIL, 70% of the asset quality issues in the system are liquidity related and 30% due to operating profitability. Besides liquidity concerns amid a weak macro environment, asset quality issues have been driven by 1) delays by government in releasing funds on executed projects, 2) rising risk aversion given high NPLs, 4) non-availability of short term financing . Furthermore, high leverage and issues of fuel availability (coal and gas) have stressed assets in the infra space.

Looking ahead, further strains on banks’ asset quality are likely emerge amid prevailing macro /policy challenges and the impact of a deficient monsoon on agriculture. A scenario analysis by the RBI suggests that under medium risk conditions gross NPL ratios would rise by 70 to 100 bps (from current 2.5 to 3.0%) during the year ending March 2013. That said, some comfort is provided by the strong capital adequacy of Indian banks which ensures that the banking system remains resilient even in the unlikely contingency of having to absorb the entire existing stock of NPLs (as per RBI stress test ).

Against this backdrop, a reduction in asset quality concerns would warrant multi-fold efforts by banks and government on operational, regulatory and policy levels. These include:

1) Further reforms on fiscal and infrastructure front: While recent thrust on policy and investment reforms by the Indian government are a big positive, further measures are needed to reduce the fiscal deficit, fast track infrastructure projects and environmental clearances and address fuel supply issues (particularly in coal). Solving project bottlenecks are vital given that infra lending accounts for 4.8% to 18.6% of loan exposure of Indian banks.

2) Augment liquidity conditions: Prevailing liquidity conditions continue to remain tight despite slowing credit growth, a recent cut in reserve ratio by the RBI and a pick up in capital inflows. The situation warrants further action by the RBI to help improving liquidity, in turn enabling banks to reduce stress by cutting interest rates.

3) Banks should avert further slippages by increasing focus on loan recovery, cost efficiency and risk management: Indian banks need to intensify their loan recovery efforts, tighten productivity benchmarks and improve project selection.

4) Strengthening existing regulatory framework on restructured loans: As suggested by a working group set up by the RBI and in line with international practices, loans that are restructured by Indian banks should be treated as impaired and be provided for. While this would increase bank provisioning on restructured advances and in turn impact near term profitability, they would do well to strengthen Indian banking sector over the long term.

Standard & Poor's: Ivan Tan, Director of Financial Institutions Ratings
The credit profile of Indian companies in general has deteriorated over the past 12 months on account of weak global and domestic demand (reflected in the slowdown in economic growth), as well as policy inaction to address structural issues in sectors such as power. Domestic consumer demand has been hit due to high inflation and interest rates. 

Companies' capital spending also slowed down due to a lack of clarity on government policies, such as on land acquisition, environmental clearances, and resource allocation. Low demand-growth expectations and high borrowing cost also hit corporate investments. At the same time, controversies such as those relating to the allocation of coal blocks, and the Supreme Court's decision on the cancellation of telecommunications licenses have increased the vulnerability of the corporate sector. 

We believe that the small and midsized enterprises are more vulnerable to weak economic conditions than large corporates, which have more financial flexibility to withstand pressure. State electricity utilities; private-sector electricity producers that face fuel shortages; some aggressive bidders for road projects; and companies in the steel, construction, commercial real estate, airlines, textiles, and engineering sectors have faced pressure over the past one year.

We expect the asset quality of Indian banks to remain stressed in the near term. We believe the percentage of nonperforming assets (NPAs) in total loans could cross 10% by March 2013, from about 7.5% in March 2012. We expect NPAs for the banking industry to exceed Indian rupee (INR) 5.8 trillion by March 31, 2013. We include nonperforming loans (NPLs), restructured loans, and foreclosed assets in our definition of NPAs. 

As per Reserve Bank of India regulations, Indian banks do not include restructured loans as NPLs; classification of such loans in India is likely to change by fiscal 2015 and be more in line with international practices. Performing restructured loans account for about 4.7% of the loan portfolio of Indian banks as of March 31, 2012 and are likely to rise sharply this year. We continue to expect about 25%-50% of the restructured book to slip into the NPL category through the economic cycle.