Boosting investor confidence in banking

Regulatory clarity and reducing information asymmetry are key to addressing NPA divergence

In FY2016 and FY2017, five Indian banks disclosed that RBI audit suggested they have under-reported the NPA numbers in their financial statements to the tune of Rs 530 bn. This NPA divergence was surprising since these banks are widely held by institutional investors and invite a higher market scrutiny. It may be argued that information asymmetry, sometimes self-imposed, with certain elements in the system exacerbated gaps in Reserve Bank of India (RBI) regulations leading to the NPA reporting fiasco. NPA and other delinquency recognition related regulation and corresponding provisioning and capital requirements remain exposed to subjective interpretation. This may provide a nudge to banks for regulatory arbitrage, to potentially resort to an opportunistic if not aggressive interpretation of such rules.

Problems associated with NPA recognition are not unique to India. The European Banking Authority (EBA) in its final report of Default definition (2016) acknowledged different practices across lenders with respect to application of the default definition. Banking regulators in advanced regulatory regimes such as Europe and Singapore tend to align with Basel’s definitions of default. This typically include days past due (DPD) criteria (90 DPD), indications of unlikeliness to pay and material deterioration of credit. The entire gamut of default events may never be captured with total objectivity and would continue to present a challenge to banking regulators.

The challenge in India is of a higher order. While the RBI has a definition of NPA it does not have even a cursory definition of "default" till now. This has laid the seeds of a host of issues including divergent NPA reporting. But thankfully they can be addressed .

Better alignment of ‘default’ and ‘NPA’: Credit rating agencies (CRA), which rate bank loans, tend to define default as an Re 1/1 day delay in servicing of debt obligations. Ratings are used to maintain capital on loan exposure. More synchronisation is required between CRA (regulated by the Securities and Exchange Board of India) default and the corresponding action of banks on the same loans. CRAs may tag a company as default after a 1-day delay in debt payment; however banks are not mandatorily required to forthwith increase provisioning because the loan may remain ‘standard’. Likewise, regulatory provisioning requirements does not increase for SMA1 (30 days-past-due) and SMA2 (60 days-past-due). To the extent CRA’s ‘C’ or ‘D’ rating loses relevance as it does not increase provision or capital requirement.

Illustration by Binay Sinha

Forward looking provisioning: Currently the global framework for provisioning, which RBI also follows, is based on an incurred loss model where provisioning requirement increases after the event of default or NPA. This framework, criticised for behind-the-curve provisioning, is making way to forward looking provisioning based on expected credit loss (ECL) as prescribed in International Financial Reporting Standards (IFRS). Indian Accounting Standard (IND AS) which seeks convergence with IFRS, is expected to the address the issue of under-provisioning during downturns. While Ind AS implementation is awaited, the RBI must decide on whether CRA’s ‘default’ tag as well as SMA1/SMA2 should call for higher provisioning. Banks that follow conservative provisioning practices keeps extra-provisions for exposures at SMA1 or SMA2. But if those banks struggling with profitability do not maintain incremental provisions, per se, they do not become non-compliant.

Harmonising default across banks: A majority of bank loan agreements have cross default clauses. The implication being that if a corporate borrower is in default on one loan it will be considered to have defaulted in other loans as well. These other loans of the borrower may then be recalled or required to make accelerated payment. Rarely has such clauses been triggered promptly when the first default happens. While such inaction is likely to add onto a bank’s losses, they are neither considered as audit or regulatory issues. In fact, if a loan is NPA with one bank and ‘standard’ with another, the RBI does not require the second bank to mandatorily keep higher provisions. The current regulations fail to recognise explicitly, the higher risk of NPA in a borrower which is already NPA with another bank. However, ECL under IND AS is expected to demand higher provisioning in such cases.

Information asymmetry addressable immediately: The existing regulations were formulated in an era where information on corporate loan default was not available. However commercial credit bureaus have evolved significantly and can facilitate implementation of the proposed regulations. CRAs struggle to find information on Re 1/1 day corporate overdue. This can easily addressed by bureaus such as Transunion CIBIL where performance of over 6 million entities with live loans is tracked. Regulation  already allow CRAs to access credit bureau records and take prompt rating action. Bureaus capture delinquency/ default events way earlier than other data sources. Select Indian banks with rigorous risk management practices extensively use corporate bureaus to regularly harmonise default across the banking system and create a watch list of potential defaults or NPA. The next logical extension is using bureau information to fine-tune provisioning estimation.

Given the evolved information infrastructure, the RBI may consider enhancing regulatory clarity by defining default, then aligning ‘default’ with NPA, harmonise default across banks and calibrate provisioning requirements with these events. While provisioning may go up temporarily, it will save banks the embarrassment of avoidable regulatory strictures and boost investor confidence in banking.

The author is chief product officer, TransUnion CIBIL, & visiting faculty, IIM Calcutta. Views are personal