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How new debt norms will ease banks' pain

Banks can now convert any amount of debt into equity, but many believe the relief will be short-lived

Manojit Saha Mumbai
In November 2010, a consortium of banks decided to convert 10 per cent of Kingfisher Airlines’ debt into equity. At that time, it was argued that it would give the struggling airline a new lease of life. In spite of this, Kingfisher Airlines was grounded two years later.

Banks purchased the shares of Kingfisher at a premium price of 61 per cent. This price was arrived at following the formula approved by the Securities & Exchange Board of India, or Sebi: the average price of the last 30 days or the last six months, whichever was higher. In hindsight, it was a bad investment. The Kingfisher Airlines stock tanked, and the banks had to book the losses, for which they drew widespread flak.

While restructuring its debt, which was to the tune of Rs 1,350 crore, bankers could not foresee what was coming. Not even the Reserve Bank of India, or RBI, which actually granted regulatory forbearance to banks in terms of waiving off higher provisioning that is required for restructured standard advances.

What happened to Kingfisher Airlines is perhaps the biggest lesson for banks and regulators on the perils of converting debt into equity. Unfortunately for the banks, it came at a time when credit growth had started to taper off and they got burdened with bad loans.

Over the next few years, non-performing assets of banks as well as restructured assets mounted. The gross non-performing assets, or NPAs, of the banking system went up from 2.3 per cent of total advances in March 2009 to 4.5 per cent in September 2014. The situation is  grimmer if all stressed assets are considered. According to RBI data, stressed assets (gross NPA + standard restructured advances) in September 2014 were 10.7 per cent of advances. Estimates by rating agencies suggest the ratio could hit 13 per cent by March 2016.

In such a scenario, the recent norms announced by Sebi regarding conversion of loans to stressed borrowers into equity could give some relief to the banks. The stressed assets will become equity investments, and will therefore help their balance sheet look better. It should help them when they go out to recapitalise themselves. However, some critics have pointed out that this will stretch the management bandwidth of the banks: they are in the business of giving loans and it is not their business to run companies, which they might have to if they become large shareholders in  companies to which they have lent money.

  But there is no doubt that the banks will get some relief — at least in the short run. According to the new norms, banks can convert any amount of debt into equity (there was a  10 per cent cap earlier) and the ‘fair’ price for conversion can be decided by the bankers in consultation with the company.

These two concessions — removal of the 10 per cent cap and doing away with the Sebi formula — will give banks more flexibility and confidence while converting debt into equity in any loan recast. RBI has said that taking equity of a company while recasting debt will not be counted while calculating a bank’s capital market exposure.

In addition, RBI’s recent 5/25 norms have made bankers optimistic about restructuring loans of firms that are in stress but can be salvaged with some ‘hand holding’. The 5/25 norm allows banks to refinance debt every five years for a maximum four times. This gives the company breathing space to repay loan without facing cash flow pressure.

The old way
Before the 5/25 rule came into existence in July 2014, a bank would typically lend to a corporate borrower from the infrastructure and core industries for a maximum of 12 years. While there was no regulatory cap on the tenure of loan, banks maintained the 10-12 year cap keeping in mind their asset-liability profile. Banks’ liabilities (deposits) have a short tenure: about one–third of all bank deposits have maturity of up to three years. This acts as a constraint on them when it comes to lending to long gestation projects.

For the companies, the new norms will mean some breathing space. Reduction of debt, through conversion into equity, will ease the cash flow. A larger equity base will also give it plenty of elbow room to leverage it for more debt. But how it will play out on a company’s earnings per share is not certain. That could affect its stock price. As a shareholder, the banks will get to have a say in the company’s decisions. It remains to be seen to what extent Indian promoters will accept this interference.

While the new rules allow banks to convert the borrower’s entire debt into equity, bankers say only 20-30 per cent of conversion is feasible. However, there is a catch. As a recent study by India Rating pointed out, the new norms are unlikely to meaningfully benefit the lenders as well as the corporate borrowers because most of the current set of large corporate borrowers are already in distress.

“Corporations classified as ‘known stress’ and ‘vulnerable’ have their market capitalisation eroded by 80-99 per cent over the last two to four years. The debt-to-market capitalisation (median) for these corporations is currently around 8.0. Thus, theoretically even if the existing shareholders are wiped out and equivalent debt is converted into equity, it would address only 10-12 per cent of the total debt,” the rating agency which tracks credit matrix of 500 large corporate borrowers said.

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First Published: Mar 26 2015 | 9:30 PM IST

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