Npa

NPA Problem & Resolution
1
INDEX
Executive Summery........................................................................................................4
1.Introduction................................................................................................................5
2. Rationale Why NPAs are so critical to the Banks................................................6
3. Origins of NPAs.........................................................................................................6
3.1. Asset Creation in Banks.......................................................................................8
3.2. Asset Monitoring in Banks...................................................................................8
3.3. Asset ecovery in Banks......................................................................................8
. Identification of NPAs !hrough Perfor"ance #$aluation %easures for !he
Banks............................................................................................................................1!
4.1 "#e o$e o% "ra&itiona$ Benc#marks..................................................................1!
4.2 "#e o$e o% Market 'riente& Benc#marks..........................................................11
4.3. An A$ternate (rame)ork....................................................................................12
4.3.1. *o) &oes one com+ute E,E-.....................................................................13
4.3.2. *o) &oes one com+ute E,E-..................................................................13
4.3.3 '+erationa$ising a Consistent Business Mo&e$............................................15
&.'aluation of NPAs.....................................................................................................15
5.1 ,a$uation o% ./As0 1i%%ering A++roac#es..........................................................16
5.1.1 "ra&itiona$ Sc#oo$s o% ,a$uation /rocesses..................................................12
./A ,a$uation Matrix 0.........................................................................................12
5.1.2 3i4ui&ation va$ue a++roac#..........................................................................21
5.1.3 Earnings mo&e$.............................................................................................22
5.1.4 Case s+eci%ic va$uation mo&e$s....................................................................22
5.2. 5sing a Market /ers+ective to)ar&s ,a$uation..................................................24
5.2.1 ,a$uing ./A /oo$s0 "#e /ro6a6$e So$ution.................................................26
(. !echni)ues of Resolution of NPAs..........................................................................22
*. NPAs in India and so"e other Asian countries.....................................................27
2.1 ./As in 8n&ia 0 An 'vervie)..............................................................................34
2.1.1 'vervie) o% /er%ormance............................................................................34
2.1.2 Sector 9ise C$assi%ication o% ./As in 8n&ia................................................35
2.1.3 Causes o% t#e ./As +ro6$em in 8n&ia...........................................................36
2.1.4 Measures a&o+te& to reso$ve ./As +ro6$em in 8n&ia...................................36
2.2 ./AS in 't#er Asian Countries..........................................................................38
C#ina.....................................................................................................................38
"#ai$an&.................................................................................................................4!
:orea.....................................................................................................................41
;a+an......................................................................................................................42
+. Resolution of NPAs in the Asian ,onte-t..............................................................43
C#ina.........................................................................................................................43
:orea.........................................................................................................................46
"#ai$an&.....................................................................................................................48
;a+an..........................................................................................................................47
.. ,o"/arati$e Analysis of NPA /ro0le" 1 resolution in India and other Asian
,ountries......................................................................................................................5!
7.1 Simi$arities 6et)een ./A +ro6$em in 8n&ia an& ot#er Asian countries..............5!
7.2 1i%%erences 6et)een ./A +ro6$em in 8n&ia an& ot#er Asian countries..............51
12. ,onclusion3 4essons for #ffecti$e Resolution of NPAs......................................51
Bi6$iogra+#y..................................................................................................................55
2
Executive Summery
It is a great pleasure to work on the project NPA Problem & Resolution!
"omparative Analysis o# NPAs in In$ia an$ some other Asian "ountries%
&eeping the economic crisis in Asian countries at the backgroun$' this project
has covere$ the NPA scenario in In$ia' "hina' &orea' (hailan$' an$ )apan
$uring the perio$ #rom *++,to -..- /A%0%1%
As a conse2uence o# economic crisis in Asia' the huge volume o# NPAs o# the
banks have been arisen in many countries% (his Non3Per#orming Assets
/NPAs1 problem is seen as the promoter o# the potential banking crisis%
4owever' NPAs problem can be converte$ into the potential revenue earner #or
the banks an$ the economy' i# they are resolve$ e##ectively%
(he project report is presente$ in 5 chapters% (he #irst chapter covers
intro$uction o# the topic% "hapter secon$ answers the 2uestion why NPAs are
so critical #or banks% (he thir$ "hapter talks about the origins o# NPAs in
general% "hapter 6our talks about i$enti#ication o# NPAs through per#ormance
evaluation measures in the banks% "hapter 6ive makes a rea$er #amiliar with
various approaches to valuation o# NPAs% (he Sixth chapter talks about the
techni2ues that are generally use$ #or resolution o# NPAs%
"hapter Seven narrates NPA scenario in In$ia an$ other Asian countries
/especially in "hina' (hailan$' &orea an$ )apan1 with the special emphasis on
the causes behin$ the NPA problem in these countries an$ the measures
un$ertaken till $ate% In the eighth chapter various resolution techni2ues that
has been speci#ically a$opte$ in some Asian countries' the challenges an$ the
propose$ mo$i#ications are stu$ie$ in $etail% "hapter Nine covers the
comparative analysis o# NPA problem an$ resolutions in In$ia an$ other Asian
contries /vi7% "hina' &orea' (hailan$' an$ )apan1% (he conclu$ing chapter (en
attempts to provi$e lessons #or e##ective resolution o# NPA problem especially
in the context o# In$ia an$ the conclusion%
3
1.Introduction
8ver the next ten years Asia coul$ emerge as the worl$9s growth engine' le$
by "hina an$ In$ia' an$ #uele$ by an in#low o# global capital' technology
trans#er' an export boom' an$ increase$ $omestic consumption% 6or Asia to
reali7e its promise' the region9s re#orm3min$e$ governments an$ regulators'
companies an$ businesses' an$ len$ers must move aggressively to clean up
:- trillion in non3per#orming loans' a legacy o# the *++.s that continues to be a
$rag on the region9s economies%
Such a vast volume o# Non3per#orming Assets o# the banks is the main
conse2uence o# economic crisis that took place in many Asian countries% At
the same time non3per#orming assets o# the banks in many Asian countries
can be seen as the probable cause o# the potential banking crisis that coul$ be
occurre$ in the #uture in these countries% In or$er to prevent such banking
crisis' the Non3Per#orming Assets o# the banks are re2uire$ to be manage$
an$ $ispose$ o## e##ectively% 4ence management o# non3per#orming assets
hel$ by the banks has become an important #unction in to$ay9s #inancial worl$
(his project has attempte$ to provi$e a more comprehensive approach to
management o# an$ resolution to the problem o# Non Per#orming Assets
/4erea#ter re#erre$ as NPAs1 o# banks (his project has also touche$ some
important areas in the per#ormance evaluation measures use$ by banks an$
cre$it process in the banks that help i$enti#y NPAs at micro level an$ macro
level% 6urther it has explaine$ various NPA valuation approaches an$
techni2ues #or resolution o# NPAs%
(he issue o# non3per#orming assets /NPAs1 in In$ia an$ some other Asian
countries /vi7% "hina' (hailan$' &orea an$ )apan1 has been $iscusse$ at
length in the #ollowing parts o# the project% (he causes behin$ the NPA
problem an$ the metho$s use$ to resolve this issue across these countries
have been analyse$ an$ $iscusse$ extensively%
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2. Rationale Why NPAs are so critical to the Banks
NPAs are a concern #or banks as they not only ero$e the value o# the assets'
but also a##ect the pro#it growth% NPA growth involves the necessity o#
provisions' which re$uces overall level o# pro#its an$ hence' sharehol$er value%
(he recovery processes are hence' vital as they tantamount to the booking o#
new business' as capital is #ree$ an$ can be $eploye$ pro#itably in the creation
o# new assets%
3. ri!ins o" NPAs
It is generally believe$ /more so a#ter the Asian crises1 that the principal
reasons whyNon Per#orming Assets /NPAs1 are create$ are systemic in nature
an$ $irectly attributable to events such as real3estate bubbles /(hailan$'
In$onesia1 or a high proportion o# $irecte$ len$ing /South &orea3 Anne
&rueger' *+++1% An implication o# such a belie# is that an e##ective way to
a$$ress these issues is either by eliminating interme$iaries entirely an$
substituting them completely by capital markets or by restricting the proportion
o# len$ing to certain sectors such as stock markets or real estate% 8ther policy
responses that have been suggeste$ to a$$ress the systemic issues inclu$e
#aster recapitalisation o# weak institutions through the injection o# private
capital /privatisation1' strengthening o# regulation' capital a$e2uacy
re2uirements' loan provisioning an$ classi#ication rules an$ establishment o#
clear mechanisms by which authorities coul$ inject resources to take over'
manage an$ ultimately sell ba$ assets o# the banking system%
It is un$eniable that systemic #actors play an important role an$ many o# the
steps $escribe$ in the previous paragraph coul$ prove to be help#ul% 4owever'
i# the goal is to $eal with NPAs /an$ more generally the health o# the #inancial
system1 in a comprehensive an$ $e#initive manner an$ root them out;' there
are perhaps an even more complex set o# #actors at play which nee$ to be
$ealt with at the level o# each in$ivi$ual interme$iary% An$' unless these issues
are $ealt with' even a#ter the systemic issues are resolve$' these problems
5
may resur#ace even in economies where on the #ace o# it many o# these
systemic issues are not operative% An$'o#ten' given the way these institutions
are owne$' manage$ an$ regulate$' these problems reach catastrophic
proportions be#ore the truth about them is un$erstoo$ at an institutional level%
(his results in a conse2uent catastrophic impact #or the system as a whole
since large groups o# institutions behave in an i$entical manner an$ there#ore'
#ace similar problems% At the same time' It also nee$s to be borne in min$ that
as the process o# integration moves #orwar$ it will become har$er an$ har$er
to insulate economies an$ #inancial systems #rom shocks that may arise in any
part o# the worl$% As conse2uence' even i# one is able to root out systemic
issues that are in country' it is not at all clear i# one will be able to insulate the
#inancial system #rom other economy3wi$e or worl$wi$e shocks% 8nce again'
there#ore' there is a case to buil$ institutions that are intrinsically strong an$
healthy by rooting out; those issues that on a continuous basis create
perverse incentive structures% 8ne more reason why it is important to $eal with
these issues urgently /rather than a#ter3the3event1 is that NPA problems are not
generally the result o# one large ba$ $ecision or just one set o# ba$ managers
or $ecision makers /no matter how senior they may be1% (he nature o# the
business is such that' in large institutions' cre$it $ecisions /both goo$ ones
an$ ba$ ones1 are being ma$e on a continuous basis across the organisation%
*
An$' while it is the cumulative impact o# several ba$ $ecisions that pro$uces
the $ebilitating impact that causes concern' it is argue$ that unless the
institutional level issues are $ealt with properly an$ on an urgent basis' several
#uture NPA bubbles may currently be in the process o# being create$% In some
banks' $riven by the same institutional issues' the reverse' a complete
cessation o# risk taking' may be happening% In an emerging economy' both
these shoul$ be causes o# serious concern%
(he cre$it process in any bank comprises three broa$ steps!
/a1 asset creation' /b1 asset monitoring' an$ /c1 asset recovery%
there are three stages in an asset9s li#e cycle% At each stage it is possible to
use a variety o# mo$ern an$ not so mo$ern tools an$ techni2ues to ensure
that one is at all times implementing a consistent business mo$el%
1
'%ten as is t#e case in 8n&ia< cre&it &ecision is #ig#$y &ecentra$i=e& >a$$ t#e )ay to t#e 6ranc# $eve$?
an& o%ten &e$egate& to in&ivi&ua$s as sanctioning +o)ers.
6
<%*% Asset "reation in =anks
(his is a key step at this stage itsel# it has to be ensure$ that!
>(he bank is taking a reasonable amount o# risk%
>(he bank is earning an a$e2uate return to compensate it #or the risk
it is taking%
>(he bank has the capital available to it to assume this risk%
A measure such as Risk A$juste$ Return on "apital /RAR8"1 can
be use$ to make this $etermination% 8ne o# the key pre3re2uisites
#or computing this number however is that the bank must possess a
trans#er pricing an$ a rating mo$el with 2uantitative numbers #or!
>"re$it Rating o# each asset%
>?atche$ ?aturity cost o# #un$s%
>Expecte$ 0e#ault 6re2uency /E061 associate$ with the rating%
>@oss Aiven 0e#ault /@A01 #or the transaction%
>Exposure at 0e#ault /EA01 #or the transaction%
>Bolatility o# 0e#ault%
>Ratings ?igration ?atrix%
<%-% Asset ?onitoring in =anks
8nce an asset has been ac2uire$ several aspects o# the per#ormance o# the
asset have to be monitore$% (hese inclu$e!
>"re$it 2uality o# the borrower
>Cuality o# the collateral
>Return on the overall capital $eploye$ to service the various
nee$s o# the borrower%
<%<% Asset Recovery in =anks
It is important to recognise that EBE is a present value measure an$ attempts
to incorporate the #un$amental #act that money has time value% In an EBE
base$ evaluation #ramework the banker is continuously attempting to
maximise recovery value in present value terms rather than in accounting
2
terms% (he recovery process then becomes much more pragmatic an$
oriente$ towar$s #in$ing 2uick solutions /even i# they are somewhat imper#ect1%
(he manner in which banks manage each o# these three phases in the li#e
cycle o# an asset $etermines the overall 2uality o# the interme$iation process
within a bank% 4owever' i# banks are to $o this well they nee$ to have a
consistent business mo$el with which to operate% A business mo$el has
several components%
Apart #rom the internal environment o# the banks' several systemic issues
coul$ also play an important role in the cre$it process o# banks%
?any o# the issues that were tra$itionally consi$ere$ to be systemic issues /#or
example over3exposure to real3estate1 coul$ perhaps be more accurately seen
to be institution speci#ic issues but that the true systemic issues ha$ more to
$o with
/a1 management o# the macro3#inancial system D har$ lan$ings versus so#t
lan$ings'
/b1 level o# interest rates D problems associate$ with very high an$ very
low interest rates' low interest rate volatility an$ secular an$
uni$irectional interest rate movements
/c1 micro3management o# banking system participants combine$ with non3
transparency in per#ormance evaluation lea$ing to! uni#ormity o#
behavior resulting in a conse2uent absence o# well #unctioning markets
an$ poorly $evelope$ internal competencies #or respon$ing to risks an$
opportunities in a rapi$ly liberalising market place% In this regar$'
*% (he overall regulatory #ramework in which the banks operate is very
crucial%
-% (he absence o# 2uick an$ e##icient system o# legal re$ress constitutes
an important Emoral ha7ar$E in the #inancial sector%
<% 0iscontinuous changes in values o# economic variables /har$
lan$ing1 such as interest rates can lea$ to imper#ect processing an$
transmission o# in#ormation as well as $istortions%
F% @ast but not the least' the role o# $evelope$ bon$ markets cannot be
overemphasi7e$% It can be argue$ that un$er$evelopment o# bon$
markets un$ermines the e##iciency o# the banking system% I# a bank
is weakly capitalise$ so that it cannot make a write $own in a loan
8
renegotiations without violating capital a$e2uacy stan$ar$s' the
bank may let the borrower continue negative present value projects
by #un$ing these activities to avoi$ $eclaration o# $e#ault% In this
case monitoring by bon$hol$ers may be pre#erable since they will
have no motive to sustain uneconomic activity% Also a bank that
operates in an economy without well $evelope$ bon$ an$ other
#inancial markets has a $iminishe$ capacity to manage risks% (he
thinness o# the $erivatives markets means that most he$ging
activities must involve expensive transactions on the balance sheet%
It will be particularly challenging to $eal with concentrations o# cre$it
risk since in the absence o# a well3$evelope$ bon$ market it will be
$i##icult to sell or securati7e loans or to negotiate cre$it $erivatives%
#. Identi"ication o" NPAs $hrou!h Per"or%ance
E&aluation 'easures "or $he Banks
(here are several issues that nee$ to be $ebate$ in the context o#
per#ormance evaluation o# banks an$ the relate$ incentive structures o# bank
employees' managements an$ =oar$ o# 0irectors%
F%* (he Role o# (ra$itional =enchmarks
Several tra$itional benchmarks are looke$ at when evaluating bank
per#ormance!
>Return on E2uity /R8E1
>Non3Per#orming Asset Ratio /NPA Ratio1
>Arowth in asset base
>"ost to Income Ratio
4owever' in the context o# a bank these measures su##er #rom several
problems!
*% (hey are extremely slow moving an$ not contemporaneous ! 6or
example' a high volume o# ba$ len$ing to$ay will show up as an
7
imme$iate increase in R8E' growth in asset base' improvements in
NPA Ratio /since the si7e o# the $enominator increases1 an$ only about
G years later show up as an increase in NPAs% As a conse2uence' to
use these measures to evaluate annual per#ormance woul$ be
inaccurate an$ will not really provi$e any in$ication o# the year3to3year
per#ormance o# a bank%
-% >(hey are relatively easy to manage in a =anking environment! (his is so
well known that phrases such as ever3greening an$ #ront3en$ing have
become a part o# the popular lexicon% An$' even with high levels o#
$isclosure' given the complexity o# a bank9s balance sheet it becomes
impossible to $isaggregate the impact o# these actions an$ correctly
#actor that into the measurement o# a bank9s per#ormance%
<% >(hey are highly inter3relate$! A high R8E may be the result' #or example'
o# incomplete provisioning or a high proportion o# tra$ing pro#its% (his
kin$ o# inter3relationship also ensures that these measures $o not
provi$e in$epen$ent measures o# per#ormance o# a bank% Since there
are multiple such measures' each o# which are not su##icient statistics' it
also becomes impossible to any kin$ o# or$inal ranking o# banks on the
basis o# these ratios or to compare bank per#ormance%
F%- (he Role o# ?arket 8riente$ =enchmarks
=enchmarks o# per#ormance which are popular in the $evelope$ markets ten$
to be linke$ to capital markets an$ woul$ inclu$e measures such as Price to
Earnings multiple' Price to =ook multiple an$ market capitalisation o# banks%
4owever' #or these to be cre$ible as benchmarks o# per#ormance!
>(here has to a reasonable amount o# li2ui$ity in the stock so as to allow
price3$iscovery to take place e##ectively%
>(here has to be a well3in#orme$ community o# sharehol$ers an$
analysts $riving these share prices%
(here has to be a well3$evelope$ market #or hostile mergers an$
ac2uisitions #or banks an$ #inancial institutions%
>It shoul$ be possible to link the un$erlying per#ormance o# a bank
relatively unambiguously to the market price%
1!
In emerging markets most o# these precon$itions $o not hol$ an$
?anagements an$ =oar$s are rarely $iscipline$ or rewar$e$ #or per#ormance H
non3per#ormance on these benchmarks% (he use o# stock options is an attempt
to $evelop these links but it has the concern that it coul$ $rive short3term
orientation in per#ormance within =anks an$ in illi2ui$ markets it coul$ also
provi$e an incentive to manage the stock price% 4owever' these benchmarks
clearly have the potential to provi$e a more accurate measure o# the
per#ormance o# a bank than $o the tra$itional benchmarks an$ woul$ be much
har$er /though not impossible1 to manage%
F%<% An Alternate 6ramework
A care#ully $evelope$ per#ormance measurement #ramework has the potential
to a$$ress many o# the issues that have been raise$ earlier!
>It can e##ectively rewar$ high per#orming banks an$ penalise the poor
per#ormers%
>It can show up the cost o# inconsistent actions by managements'
sharehol$ers an$ the regulator an$' there#ore' $rive internal
consistency in the entire system%
@=uil$ incentives to ac2uire the relevant competencies at all levels right
#rom the =oar$ to the employee base o# a bank%
(ne measure that has this potential is the Economic Balue o# E2uity /EBE1
/reporte$ both per share as well as an aggregate 2uantity1 an$ an associate$
2uantity' which may be re#erre$ to as the Economic Balue o# E2uity at Risk
/EBER1% It is argue$ that this is a su##icient set o# statistics so that when
measure$ an$ reporte$ on a monthly /it can even be measure$ real3time i#
re2uire$1' 2uarterly or annual basis' it provi$es nearly complete in#ormation on
the true per#ormance o# a bank over that perio$% Ihile behaviour o# the EBE
captures value a$$e$ or subtracte$' when combine$ with EBER' it provi$es a
win$ow into the riskiness o# a bank% An$ the ratio o# the two provi$es in some
sense the return per unit o# risk o# a bank an$ may be use$ #or $eveloping an
or$inal per#ormance measure #or banks%
11
F%<%*% 4ow $oes one compute EBEJ
(he EBE may be viewe$ as the instantaneous li2ui$ation value o# a bank
assuming $eep an$ li2ui$ markets' i%e%' i# all the assets an$ liabilities o# a bank
were to be strippe$ an$ sol$ in the market' at current market prices /with 7ero
impact cost1 the EBE woul$ be a measure o# its net realisable value% (his is
typically compute$ by taking the marke$3to3market value o# all the assets o# a
bank /using current cre$it sprea$s an$ current interest rates1 an$ subtracting
#rom that the current marke$3to3market value o# its liabilities% Ihen compute$
on a monthly or 2uarterly basis it computes the net impact on the bank o#
various events an$ actions!
>A@? strategy
>Impact o# interest rate movements
>Port#olio ?anagement strategy
>Impact o# changes in cre$it 2uality o# asset port#olio
EBE can then be compare$ with the =ook Balue o# the bank to $etermine i# the
book value properly re#lects the (rue an$ 6air; picture o# a bank%
-
It is
believe$ that EBE is a much more accurate representation o# the value o# a
bank an$ is there#ore likely to be closer to the market capitalisation or market
price o# the bank9s share%
F%<%-% 4ow $oes one compute EBERJ
A relatively simple way to compute EBER woul$ be to simply compute the
value o# EBE with the #ollowing scenarios!
>A one3notch $owngra$e in ratings o# all assets an$ a one percent
parallel shi#t in interest rates upwar$s%
A one3notch $owngra$e in ratings an$ a one percent parallel shi#t in
interest rates $ownwar$s%
>A one3notch upgra$e in ratings o# all assets an$ a one percent parallel
shi#t in interest rates upwar$s%
@A one3notch upgra$e in ratings o# all assets an$ one percent parallel
shi#t in interest rates $ownwar$s%
2
E,E o% a 6ank A %inancia$ institution A insurance com+any )ou$& 6e simi$ar to t#e .A, o% a Mutua$
(un&
12
(he highest negative impact on EBE woul$ be reporte$ as EBER% It is certainly
possible to $o this more care#ully with multiple probability weighte$ scenarios
an$ i# care#ully $one woul$ yiel$ a much more accurate representation o# the
risks embe$$e$ in the balance sheet o# the bank%
Ihile changes in EBE over the current EBE provi$e a much more accurate
measure o# R8E' EBER itsel# may be compare$ with the (ier * capital base o#
a bank to $etermine i# the bank has su##icient capital to cover the risks
embe$$e$ in its strategy%
EBE an$ EBER provi$e the as3is measures o# a bank9s per#ormance%
4owever' it is possible that a bank is prepare$ to sacri#ice current per#ormance
in the pursuit o# a longer3term strategy an$ sometimes =oar$s o# banks ask #or
a more #uture oriente$ measure o# the per#ormance o# the bank which
incorporates not only the #uture impact o# the current business /EBE an$
EBER $o that1 but also #uture impact o# #uture business $ecisions an$ is more
$riven o## the Pro#it an$ @oss statement' unlike EBE an$ EBER which are more
=alance Sheet base$% (hese measures are re#erre$ to as Sharehol$ers9 Balue
A$$e$ /SBA1
<
metho$s an$ are most use#ul in combination with EBE an$
EBER as measures by which =oar$s may exercise a more $irect control over
the managements o# =anks while allowing them a consi$erable $egree o#
operational #ree$om%
EBE an$ EBER coul$ also become e##ective metho$s by which the regulator
coul$ exercise a macro3level control over the banks% Aiven the nature o# the
metric it is not only a su##icient statistic' it is also very easy to un$erstan$
intuitively an$ $oes not su##er #rom the long3cycle problems o# the earlier
metrics% It woul$' there#ore' provi$e the lay sharehol$er also a goo$ insight
into the actual per#ormance o# the bank on a perio$ic basis% (hese ratios coul$
also $rive the $evelopment o# internal competencies at all levels as =oar$s'
managements an$ employees strive to un$erstan$ an$ manage to the $rivers
o# these two metrics%
F%<%< 8perationalising a "onsistent =usiness ?o$el
As $iscusse$ earlier' 8nce an EBE an$ EBER base$ approach to bank
evaluation is accepte$ it becomes possible to ensure that at each stage in the
3
e%er BEva$uation o% Banks using S#are#o$&ersC ,a$ue A&&e& A++roac#esD 6y /a&#ye an& S#arma
>2!!2?
13
li#e3cycle o# an asset the actions that are being taken are consistent with the
goal o# maximising EBE' subject to an acceptable level o# EBER%
Ihile consi$erable scope #or improvements exists' in emerging markets like
In$ia rating agencies are now able to provi$e a goo$ set o# estimates an$
mo$els #or all o# these% It is also possible to create a share$3service so that
one or more mo$els can be applie$ against these assets at a low cost to the
=ank' by an outsi$e agency /Application Services Provi$er D ASP1% It is
possible to show that managing a bank with RAR8" being tracke$ at the level
o# each transaction an$ the level o# each client e##ectively ensures that the
EBE is being maximise$ subject to a given level o# EBER%
8nce it is clear that the EBE o# the bank is being monitore$ on a monthly
basis' the management an$ the sta## have a very high incentive level to ensure
that they monitor their borrower very care#ully on a regular basis an$ take
proactive action whenever the borrower encounters any $i##iculty% (he EBE
measure captures #ully any $owngra$es in the asset 2uality on a regular basis
well be#ore an asset becomes non3per#orming%
(.)aluation o" NPAs
(he issue o# non3per#orming loans /NPAs1 has been $iscusse$ at length #or
the #inancial systems all over the worl$% (he causes are known an$ the
metho$s to resolve this issue have been $ebate$ extensively in various
#orums% 4owever' the interesting issue pertaining to NPAs that has not been
a$e2uately $iscusse$ is the valuation an$ sale techni2ues use$ to $ispose o##
these assets%
"ountry experiences show that banks usually trans#er the assets to an Asset
?anagement "ompany /A?"1' which in turn' $ispose o## these assets /Ioo'
-...1% (he valuation metho$s use$ $o vary between countries an$ within
countries between banks an$ A?"s% (he general consensus is that there is
consi$erable subjectivity that comes in an$ a single rule cannot be applie$ #or
all cases% (here#ore' speci#ic metho$s use$ by $i##erent banks coul$ throw light
on the options that are available #or the resolution o# this issue%
Baluation o# NPAs is a crucial exercise that shoul$ i$eally be stan$ar$i7e$
across the #inancial systems% (hese techni2ues are necessary to take
14
in#orme$ $ecisions regar$ing asset purchase price as well as the timing an$
the nature o# sales transactions an$ other sales strategies% (hey must relate to
the $isposition strategies an$ shoul$ be base$ on realistic values% (he i$ea is
to minimi7e the time #rame towar$s resolution o# this issue an$ also extract
value #rom such assets% (he valuation proce$ure can also in#luence other
$ecisions such as whether or not to provi$e seller #inancing or to #un$ asset
enhancements% Baluation shoul$ play a major role in $eci$ing whether or not
to engage in $ebt3e2uity swaps with borrowers or in $etermining the #un$ing
cost o# provi$ing e2uity participation%
(he $i##erent approaches towar$s valuation 8# NPAs are $escribe$ below in
$etail with examples to illustrate the techni2ues
G%* Baluation o# NPAs! 0i##ering Approaches
NPAs are a by3pro$uct o# most #inancial systems an$ the level o# NPAs is an
in$icator o# the health o# the #inancial system o# an economy% Baluation
techni2ues shoul$ present the situation' which maximi7es the overall interests
o# all the concerne$ parties% (he broa$ objectives o# the valuation #ramework
are essentially!
>(o set a soun$ basis #or the selling bankH institution to #inali7e the sale
o# assets'
>(o provi$e a basis #or the #air market value o# the assets'
>(o promote transparency o# the valuation processes' an$'
>(o comply with internationally accepte$ practices%
(he valuation o# an asset or the pool o# assets is a precursor to any
restructuring exercise% Any valuation exercise shall attempt to a$$ress the
#ollowing issues!
*% >(he #air market value o# the asset shoul$ represent the price at which
market participants woul$ un$ertake a restructuring%
-% >(he transaction value shoul$ re#lect the potential #or income generation
an$ return o# principal' balance$ against the applicable risk pro#ile an$
market len$ing margins%
<% >(he valuation #ramework shoul$ allow #or valuation o# speci#ic assets
as well as a port#olio o# assets /i%e% port#olio o# loans to be ac2uire$
15
#rom a bank1% In most cases' a single value will apply to each loan
ac2uire$%
6or larger loans' however' an element o# riskH return sharing with the selling
bank may be consi$ere$%
(he valuation approaches can be classi#ie$ into two parts i%e% /i1 tra$itional
approaches an$ /ii1 unconventional approaches%
G%*%* (ra$itional Schools o# Baluation Processes
(here are various metho$ologies use$ to value the companies or their $ebt%
(ypically cash #lows' assets or replacement values' or a combination o# these'
are consi$ere$ when $etermining the value o# a company or its $ebt%
NPA Baluation ?atrix !
Risk
pro#ile
@ower
Risk Pro#ile @ower 4igher
(he matrix shows the risk pro#ile o# the NPA base$ on its cash #lows an$
collateral% As shown' stronger the cash #lows an$ collateral' lower the risk
pro#ile o# the asset% Some o# the wi$ely use$ approaches towar$s valuation o#
an NPA by the valuation #irms are $etaile$ as un$er!
>0iscounte$ cash #lows
>@i2ui$ation H sale o# assets
>Earnings mo$el
>"ase speci#ic valuation mo$els
16
(KPE 86 NPA Strength o# "ollateral
#ullH over security partial security
S
t
r
e
n
g
t
h

o
#

c
a
s
h

#
l
o
w
Partial
Repayments
NPB on cash #lows to
len$er #rom interim
payments an$ assets
reali7ation%
NPB on cash #lows
to len$er #rom
interim payments
an$ assets
reali7ation%
No
Repayments
Npv on cash #lows to
len$er #rom reali7ation
o# un$erlying assets%
NPB on cash #lows
to len$er #rom
reali7ation o#
un$erlying assets%
0iscounte$ cash #lows
8ne o# the commonly use$ metho$s #or estimating the value o# the company9s
$ebt is the anticipate$ cash #lows% (he cash #low stream will represent the
interest an$ principal payments expecte$ to be receive$ by the len$er'
primarily arising out o# the internal cash #low generation #rom un$erlying
business activities%
Ihere the asset is a partly complete$ project' the cash #low stream will have
to take into account whether the project will be complete$ an$ i# so how it will
be #inance$% I# certain len$ers $eci$e to #un$ this through exten$e$ #acilities'
this will be taken into account in the assetLs cash #low stream% Essentially the
$ecision on the project9s #inancial viability will be $etermine$ by using an
incremental cash #low analysis% Normally' the value o# a healthy asset is
compute$ as the $iscounte$ value o# the expecte$ #uture cash #lows% 4owever'
a company in $istress or an NPA may have negative earnings /pro#it be#ore
interest' $epreciation an$ tax1 an$ may be likely to incur operating losses #or
the next #ew years% 6or such companies' the estimation o# #uture cash #lows is
not so easy' as there is a strong possibility o# bankruptcy /0amo$aran' *++F1%
Mn$er such a scenario the asset valuation is also base$ on subjective
parameters%
A company un$er #inancial $istress has some or all o# the #ollowing
characteristics! operating loss' inability to meet the $ebt obligations an$ high
$ebt e2uity ratio% Ihen $ealing with such cases' the cre$it analysts nee$ to
evaluate the possibility an$ timing o# positive #inancial per#ormance o# the
company in #uture which may be $epen$ent on the in$ustrial scenario'
possibility o# in#usion o# a$$itional #un$s an$ the overall macro economic
environment% I# the company is expecte$ to improve its #inancial position in the
#uture' the #ollowing $iscounte$ cash #low mo$el /(able *1 may be use$ #or the
$istress companies H NPAs%
(able *
(he =asic ?o$el
Kear * - < %%*.
E=I0(A *.. **. *-. *+.
@ess!
12
Normal "apital Expen$iture
?argin ?oney #or A$$itional Iorking "apital
(ax an$ any other statutory payment
Interest on the working capital
(otal F. F- FG 5.
6ree 8perating "ash 6lows /68"61 N. N5 ,G **.
0iscounting Rate *-O
NPB o# the 68"6 /N68"61 <..
@ong (erm 0ebt /@(01 <N.
O o# N68"6H @(0 .%5<
(he above numbers are #or illustrative purpose only%
It has been assume$ that certain expenses like normal capital expenses'
margin money #or a$$itional working capital' regulatory payments an$ interest
on the working capital shall have priority vis3a3vis the obligations towar$s long
term $ebt% As a result' the in#lows to the company less the above payments i%e%
6ree 8perating "ash 6lows /68"61 shall be available to the term len$ers%
6urther' in the above mo$el' it has been assume$ that the company shall
operate as a going concern beyon$ the above tenure o# ten years an$ so it
nee$ not re$eem its working capital borrowings' which in any case is normally
secure$ by current assets o# the company% (hese current assets normally shall
be su##icient to enable the company to re$eem its working capital loans' in
case the company ceases to exist beyon$ the above tenure% 4ence
re$emption o# only term $ebt has been assume$ in the above mo$el%In the
above mo$el' N68"6 is compare$ to the long3term $ebt o# the company an$ i#
the above ratio is more than *' the company is likely to service the entire $ebt%
(he balance amount shall #low to the e2uity hol$ers o# the company% 4owever
in case the above ratio is less than one' the $ebt shall not be #ully covere$ by
the cash #lows o# the company an$ shall be value$ at a $iscount to its current
value% (he $iscount shall be e2uivalent to the short#all o# N68"6 vis3a3vis the
long3term $ebt%
Some analysts have' however' attempte$ to exten$ the above mo$el to
provi$e returns to e2uity hol$ers as well% (his extension is base$ on the
argument that' i# the O age o# N68"6 H @(0 is less than one' the e2uity
hol$ers /inclu$ing promoters1 woul$ not get any returns over a signi#icant
tenure in #uture% In such a scenario' there is no major incentive #or the
18
promoters to work #or the company% =ase$ on this argument they have
exten$e$ the above mo$el as $etaile$ in (able -%
(able -
(he Exten$e$ ?o$el
E2uity "apital *F.
(otal "apital /("1
/@ong (erm 0ebt P E2uity1
G..
@oss to "apital hol$ers
/G.. D <..1
-..
@oss to $ebt hol$ers
/-.. Q <N. H G..1
*FF
(he above numbers are #or illustrative purpose
Accor$ing to this mo$el' the $ebt hol$ers an$ e2uity hol$ers shall share the
losses in an e2ual proportion% As a result' i# $ebt comprises ,-O o# the total
capital /as is the case above1' ,-O o# the loss shall be borne by the $ebt
hol$ers an$ the balance by the e2uity hol$ers%
4owever' base$ on various contractual arrangements between the company
an$ its len$ers' as also the control mechanisms available with len$ers' the
mo$el may not hol$ true% (his is so because a company may not be allowe$ to
provi$e any returns to its e2uity hol$ers in case o# its inability to provi$e #ull
contractual returns to the $ebt hol$ers%
6urther' the above basic mo$el is base$ on the assumptions #ormulate$ by the
len$ers /primarily in terms o# E=I0(A1 which are generally conservative% An
e2uity hol$er who has higher risk appetite normally woul$ have built in much
higher E=I0(A' resulting in possibly #ull $ebt coverage an$ $ecent e2uity
returns%
Sensiti7ation o# the mo$el
(he above process /basic mo$el1 is the likely approach to be a$opte$ by the
seller o# the $ebt% 4owever' the buyer o# the $ebt' with a view to negotiate
better' woul$ like to sensiti7e the cash #lows in terms o# lower capacity
utili7ation' lower prices o# en$ pro$ucts' higher input prices' $ebt service cover'
etc%
17
(he above shall increase the $iscount to the $ebt an$ hence' the buyer shall
try to buy the $ebt at a lower value% (he buyer may hence' insist on keeping a
$ebt service ratio o# *%-G or so i%e% minimum 68"6 to be *%-G times the term
$ebt% (his shall #urther bring $own the $iscounte$ value o# the $ebt% In
practice' one o# the above two sensitivities may be employe$ #or arriving at the
#inal valuation o# the $ebt%
G%*%- @i2ui$ation value approach
I# the loan is in $e#ault with no or low expectation o# it being service$' the cash
#low #rom li2ui$ation o# the asset an$ collateral will be the primary approach
rather than the net present value o# the cash #lows% In this case' the take3out o#
the len$er is primarily by way o# exercise o# their rights on the asset an$
attache$ collateral% (he li2ui$ation value o# the company is the aggregate o#
the value o# the assets o# the company i# sol$ at the market prices' net o#
transactions an$ legal costs% (he estimation o# the assets becomes 2uite
complicate$ when the assets o# the company can not be easily separate$ like
in a steel' textile or petrochemical plant% I# such assets are sol$ in$ivi$ually'
majority o# the asset may not #etch a price closer to their book value /or when
they are sol$ as a bun$le1% 6urther' when such sale is to take place at a 2uick
pace' the value o# the assets #urther #all $own' as it is more or less e2ual to
#orce$ sale o# these assets% As a result o# this #orce$ sale' the seller has to
accept a $iscount on the #air market value o# such assets% In most cases' such
a reali7ation is not able to cover even the secure$ $ebt #ully an$ hence the
valuation o# the $ebt woul$ be limite$ by this reali7able value%
(his approach has been wi$ely use$ in countries like (hailan$ where a
signi#icant number o# loans were secure$ by real estate an$ other marketable
securities o# various kin$s%
G%*%< Earnings mo$el
In per#orming companies' the PHE ratio o# the in$ustry or other similar
companies may be use$ as a tool #or $etermining the market value o# the
assets o# company% I# the $ebt o# the company is more than its assets' then a
proportionate $iscount may be applie$ to the $ebt% (he above approach'
however' cannot be use$ #or most o# the NPAs' as they woul$ have negative
2!
EPS% In such cases' the cash earning per share o# the company an$ cash PHE
ratio o# the similar companies may be use$ to arrive at a market value o# the
assets% (his shall enable the analyst to arrive at a reasonable valuation o# the
NPA $ebt%
G%*%F "ase speci#ic valuation mo$els
0epen$ing on case to case' various mo$els have been evolve$ an$ use$ #or
speci#ic re2uirements% Ie shall $iscuss here one o# such mo$els to provi$e an
i$ea as to how varie$ the mo$els can be #rom the conventional approaches%
Segmentation into buckets
6or a huge port#olio o# small loans' $i##erent kin$ o# approach may be use$ #or
arriving at the realistic valuation% 8ne o# them is categori7ing the loans in
various buckets an$ then analy7ing a sample picke$ #rom various buckets%
Post currency crisis o# late *++.9s in (hailan$' the price o# real estate ha$
$ecline$ to abysmally low levels an$ majority o# the property3linke$ loans ha$
become NPAs in the books o# the local banks% 8ne o# the lea$ing #inancial
companies in the worl$ was contemplating to purchase these loans totaling
over -.'... small loans% 6or arriving at the appropriate valuation' they ha$
#ollowe$ the #ollowing metho$ology!
>Segmentation o# the assets in various buckets
>Selection o# a sample out o# each bucket
>0etaile$ analysis o# each sample
>Statistical extrapolation o# the sample to the entire bucket
>Arriving at the #inal range o# the valuation o# the port#olio
Segmentation o# the assets in various buckets
(he entire pool o# -.'... loans was $ivi$e$ into various buckets base$ on the
#ollowing criteria!
si7e o# the exposure
type o# collateral
$uration o# the $e#ault%
=ase$ on the above classi#ication' the matrix was $esigne$ as given in (able <%
(able <
21
(he "lassi#ication ?atrix /No% o# loans1
SecurityH Exposure R MS0.%Gmn MS0.%G3-mn S MS0-mn
Secure$' @i2ui$ F... -G.. F..
Secure$' Non3
li2ui$
GG.. FG.. GG.
Mnsecure$ *G.. *... G.
(otal **... 5... *...
Selection o# a sample out o# each bucket
(he number o# assets in each bucket was ranging #rom G. to GG..% 8ut o#
each bucket' about -.3<. assets were chosen at ran$om' so as to get a
sample representing by an$ large all types o# assets in that pool% All such
assets totaling to about -G. were analy7e$ in $etail by the $ue $iligence team
over a perio$ o# -3< months%
0etaile$ analysis o# each sample
(he analysis o# these assets comprise$ the #ollowing! type o# property' status
o# title o# the property' con$ition o# the property' location' current market price'
current #orce$ market price' expecte$ price a#ter a certain perio$ an$ expecte$
cash #lows #rom lease H rent o# such property%
Statistical extrapolation o# the sample
A $etaile$ sensitivity analysis was carrie$ out #or each property in terms o#
lower lease rentals H lower market price' higher time #or $isposal o# the
property etc% A#ter all this analysis o# each in$ivi$ual asset' a value was
assigne$ to each o# the -G. asset in various buckets% Each bucket sample
results were extrapolate$ #or the entire bucket by using complex statistical
metho$s% =ase$ on this' the total $iscounte$ value o# the in$ivi$ual bucket was
calculate$ an$ the aggregate sum was arrive$ at as the consoli$ate$ range o#
the valuation o# the entire port#olio o# over -.'... assets%
In the above section' various conventional approaches #or valuation o# NPAs
have been outline$% 4owever' I have also attempte$ to analy7e an$ resolve
the above issue with unconventional approach% In the #ollowing section' a
newly $evelope$ approach #or valuation o# NPAs is $escribe$ an$ analyse$%
22
G%-% Msing a ?arket Perspective towar$s Baluation
In the #inancial worl$' it is a well3known #act that the whole can be greater than
the sum o# parts% (his #orms one o# the basic tenets #or the $ebt re3packaging
market' which overlaps the high yiel$ collaterali7e$ 0ebt 8bligations /"081
market% "08s encompass re3packaging o# collateral o# corporate loans an$
$ebentures o# varying gra$es% In comparison to a $irect purchase into the
un$erlying collateral' investors pre#er purchase o# pool o# non3per#orming
assets as securities or notes as they o##er better security% Iith a view to assign
a market value to such non3per#orming assets' the process o# setting up "08s
an$ securiti7ation o# NPAs is being extensively use$ in the international market
an$ speci#ically the Italian market%
International rating agencies have a well3$e#ine$ hybri$ approach towar$s the
asset pools #or obtaining the levels o# cre$it enhancement H over3
collaterali7ation% =y using this as a base' an approach has been outline$ with
a view to assign some $iscounting #actor to the book value o# the loans%
In all approaches towar$s $ebt re3packaging in $evelope$ markets' #irst o# all
the expecte$ loss on the un$erlying pool o# rate$ $ebt is estimate$% (he
expecte$ loss is the pro$uct o# maximum possible loss that can be incurre$ on
$e#aulte$ loans an$ the $e#ault probability% (he #un$amental buil$ing block
here relies on the historical $e#ault experience o# rate$ corporate $ebt' which
provi$es an estimate o# the cumulative $e#ault rate over the tenure o# the loan'
as a #unction o# the initial rating on the $ebt% (hese provi$e the expecte$ or
base case $e#ault assumption%
23
(able F
=ase "ase an$ Stress 0e#ault Rates /Percentage1
"ollateral
Ratings
=ase
0e#ault Rate
AAA
Stress
"ase
AA
Stress
"ase
AAA *%. *%< *%.
AA *%- -%< *%F
A *%< G%. F%<
=== F%. *F%. *-%.
== *N%. GF%< <+%+
= -+%+ N,%- G-%<
(he above table represents cumulative $e#aults as a percentage o# the original
#ace value over a ten3year perio$%
In the absence o# a rating' which is more pertinent to the In$ian market' a
mapping scheme that links the internal risk gra$es /pertaining to risk
$epartments o# banks or institutions1 to cre$it ratings can be use$% Possibly in
other instances' a sha$ow rating may be in#erre$ #rom other publicly rate$ $ebt
o# the $ebtor or #rom the last three years9 #inancial statements o# the $ebtor% I#
all #ails than a $e#ault; rating o# 0 is applie$% =ase$ on either the explicit or
assigne$ ratings #or each $istinct asset in the pool' an$ a rating #actor that
translates the alpha3numeric rating into a strictly numeric scale' a weighte$
average can then be calculate$ #or the asset pool% (he rating #actors provi$e
#or a sharp acceleration o# #actor weights as one moves $own the cre$it
spectrum% 6or example' in a scheme employe$ by 6itch I="A' a AAA;
instrument has a #actor o# *' whereas a 0e#ault gra$e instrument has a rating
#actor o# N.<% (hese rating #actors can then be average$ using the loan
amounts in each rating category as weights% (he numerical weighte$ average
rating is then mappe$ backe$ into an alpha3numeric rating category #or
estimating a baseline or expecte$ $e#ault rate in the overall pool' base$ on the
statistics provi$e$ in the table% (he $esire$ rating #or the securities $etermines
the stress case $e#ault probabilities employe$ #or stressing the un$erlying
cash #lows% Aiven a cumulative level o# $e#aults' another important ingre$ient
in the valuation #or $eriving a rating matrix is the timing o# the $e#aults% A
24
conservative assumption so as to assume worst case scenario stress can be
ma$e to #ront loa$ total $e#aults' so that approximately hal# the $e#aults occur
in the #irst two years%
G%-%* Baluing NPA Pools! (he Probable Solution
(he valuation mo$el' its cash #lows an$ the resultant value o# the NPA port#olio
can be $erive$ as an interplay o# the Iater#all Structure; o# tranching the pool
#or a "08' hence' calculating the over collaterali7ation re2uire$ thus ac2uiring
a estimate to the $iscount on the NPAs% (he proce$ure to be #ollowe$ is
outline$ below%
Asset Si$e
>(o $etermine the characteristics o# the port#olio /Secure$ vs% unsecure$
NPAs1%
>(o analy7e the e##iciency an$ the recovery strategies o# the service
provi$er%
>(o $etermine eventual support mechanisms such as limite$ recourse
loans an$ service provi$er a$vance #acility to meet short#alls in case o#
repackaging the $ebt an$ selling it through a "08%
@iability Si$e
>(o $etermine the water#all o# payments in the $i##erent classes o# notes
in the
"08 /subor$ination capital an$ or interest1%
>(o analy7e eventual support mechanisms /such as over collaterali7ation
#actors1%
/?oo$y Respon$s' -..*1
?o$eling Process
Even though the asset class in this case is non3per#orming the cash #low
mo$eling pattern to be #ollowe$ is the same as other asset classes% (he mo$el
can #urther be a$juste$ #or 2ualitative #actors such as legal processes' service
provi$er9s impact etc%
25
6or NPAs whilst un$ertaking a loan3by3loan analysis to $erive a cash #low' one
has to look #or a #air value between the outstan$ing loan /gross book value1
an$ the #orce$ sale value at the expecte$ recovery $ate% (he #orce$ sale value
is $erive$ #rom the last known market value /at times available #rom the
appraisal at time o# initial $isbursement1 an$ some in$epen$ent projections
about the real estate market in case o# property or in case o# other collateral
an in$epen$ent assessment o# the possible pro$uctivity value% 8nce the cash
#low mo$eling #or the asset pool has been complete$' an over collaterali7ation
test shoul$ be run using the rating agency mo$el an$ this process comprises
running the cash #lows through the water#all mechanism; mentione$ above%
(he water#all structure; provi$es an estimate as to the over collaterali7ation or
support re2uire$ to sell the pool as a re3package$ investment gra$e security in
a "08 #orm% As mentione$ the over collaterali7ation #actor can be implie$ to
give the $iscount #actor #or the asset pool an$ give an in$ication as to the price
o# the unpackage$ asset%
*. $echni+ues o" Resolution o" NPAs
*% Asset ?anagement "ompanies /A?"s1 H Asset Reconstruction
"ompanies /AR"s1
"ountries across the globe' have ma$e extensive use o# Asset ?anagement
"ompanies /A?"s1 H Asset Reconstruction "ompanies /AR"s1 #or the
management an$ $isposal o# NPAs% (hese companies either hive$ o## #rom the
balance sheet o# a #inancial institution or restructure the corporate $ebt%
Structure o# the A?" H AR"
(he A?" H AR" may be a public company or a Private company% 4owever
opinions an$ #in$ings o# the experts suggest the mixe$ structure where the
government woul$ play its role in policy $evelopment an$ maintaining overall
26
Input on assets
/recovery' timing'
support mechanism
Mo&e$$ing o%
cas# %$o)s o%
./A +ort%o$io
Cas# %$o)
mo&e$
Ex+ecte& $oss rates E
severity rates on
+ros+ective notes
accountability while private sector is involve$ in part #un$ing an$ operational
aspects%
8perational ?o$el o# A?" H AR"
Experience across the globe has shown < basic operational mo$els that exist%
(hese are!
*% Acting solely as a broker% E%g% &8?"8 in &orea
-% 8utsourcing core activities% E%g% ="A in (hailan$
<% "on$ucting activities in 4ouse% E%g% I=RA in In$onesia
(he latest mo$el o# A?" H AR" is a 4ybri$ mo$el in which such A?" H AR"
Acts as a broker #or non3contentious loans with high recovery
value where special regulatory powers a$$ little value%
8ut3sources core activities #or mi$3si7e$ loans where execution
capabilities count the most%
Activities are con$ucte$ in3house #or large contentious obligors
where special regulatory powers are critical%
Special regulatory powers can inclu$e power to sei7e assets an$ #orce
closure%
-% (he use o# securiti7ation to resolve NPAs
(he impact o# the various #inancial crises has been to signi#icantly increase the
number o# non3per#orming loans in the books o# many banks an$ #inancial
institutions% Securitisation o# these ba$ loan port#olios has many attractions'
primary among them being release o# capital by removal o# these non3
per#orming assets #rom the balance sheet o# the originating banks' better
management o# non3per#orming loans by specialise$ agencies' an$ appeal to
high risk investors looking #or signi#icant gains% Increasing number o# non3
per#orming loan securitisation $eals are being $one in various countries
ranging #rom )apan to &orea%
In recent times' securiti7ation has been use$ by banks an$ A?"s to $ispose
o## their NPAs% (he securiti7ation market has hence' assume$ a role o#
speci#ic importance in the context o# NPAs /&en$all' *++N1% Asset securiti7ation
is the conversion o# assets or cash #lows into securities' which are typically
rate$ an$ calle$ Asset3=acke$ securities /A=S1% (his has become popular #or
22
the $isposal o# NPAs as it brings with it bene#its to both the issuer an$ investor%
6or issuers' it o##ers cheaper an$ more e##icient #un$ing #or operations
combine$ with greater balance sheet #lexibility% 6or investors' securiti7ation
provi$es a broa$ selection o# #ixe$ income investment alternatives' most with
higher cre$it ratings' higher yiel$s' less $owngra$e risk than corporate bon$s
an$ more stable an$ pre$ictable cash #lows than other #ixe$ income securities%
Bariants that have been intro$uce$ inclu$e ?ortgage backe$ securities /?=S1
an$ "ollaterali7e$ bon$ an$ loan obligations /"=8s an$ "@8s1%
A "=8 is an asset backe$ security supporte$ by an un$erlying port#olio o# high
yiel$ bon$s /Albulescu1% (hey are set up to capture the arbitrage sometimes
available #rom the yiel$ $i##erential between the high yiel$ an$ investment
gra$e $ebt markets% (hey are create$ by issuing multiple $ebt tranches to
investors to #inance the purchase o# the un$erlying port#olio% (he most senior
tranche receives investment gra$e status by virtue o# priority call on the cash
#lows #rom the high yiel$ $ebt port#olio% (he other tranches have junior priority
rights to this cash #low% (he most junior tranche is consi$ere$ e2uity' which
receives income a#ter all the income sprea$ a#ter commitments to the senior
tranches an$ expenses are met% (his process can be use$ in the $isposition o#
NPAs where the asset can be sol$ in this manner such that the claims on the
cash #lows woul$ #ollow a pre3$etermine$ pattern%
,. NPAs in India and so%e other Asian countries
Asia to$ay #aces a even bigger challenge in $ealing with its NPA crisis% A
global economic slow$own' government hesitancy' an$ inconsistency in
$ealing with the NPA problem' an$ len$er complacency an$ other issues have
cause$ the region9s NPA volume to jump <<O to :- trillion currently' accor$ing
to our estimate% 8# that amount' )apan accounts #or about :*%- trillion or N.O
o# the total an$ "hina #or about :F5. billion or -GO%
(he volume o# NPAs in the port#olios o# major banks in Asia is about :- trillion'
as per the estimates by Ernst & Koung% (his estimates o# Asia9s NPA volume is
about $ouble the o##icial estimate o# the region9s "entral =anks an$ other
institutions% (here are several reasons #or this!
0e#inition o# NPA
28
An NPA is a loan that is not in compliance; with the original loan agreement%
6or example' the loan agreement coul$ have provisions that woul$ accelerate
the collection o# the loan i# certain con$itions are not met% (hese provisions
may have nothing to $o with the loan9s ultimate value; or borrower9s ability to
service the loan or repay it when it comes $ue%
@ack o# universal NPA stan$ar$
(here is no universal stan$ar$; #or $etermining when a loan becomes
nonper#orming T in many countries' a loan is nonper#orming a#ter it has been
$elin2uent #or +. $aysU in other countries' *5. $ays% 8nce a loan becomes
nonper#orming' the len$er must classi#y it as special mention'; substan$ar$';
$oubt#ul'; or loss%; Each country has slightly $i##erent $e#initions #or these
categories% 0etermining the appropriate category #or an NPA is a complex'
subjective process% (he same NPA might be categori7e$ as $oubt#ul; by one
len$er an$ substan$ar$; by another% (his is more than a matter o# seman3tics!
an NPA9s classi#ication $eter3mines the amount o# reserves that a len$er must
set asi$e against possi3ble #uture losses #rom $isposition o# the loan%
@ack o# stan$ar$ valuation metho$ology
(here is no stan$ar$ valuation metho$ology #or #inancial institutions to #ollow in
establishing appropriate reserves #or potential loan losses that might result
#rom resolution o# NPAs% In the absence o# such a metho$ology' global
investors who have been ac2uiring Asian NPAs are applying a commonly
accepte$ stan$ar$! $is3counte$ cash #low% In competitive auction bi$$ing'
these investors have been ac2uiring NPAs at current #air market value prices
ranging #rom *.O to <.O o# book value%
Political pressures
Asia9s governments are concerne$ about the social an$ politi3cal
conse2uences o# pressuring banks to $ispose o# NPAs or corporations to she$
unpro$uctive assets! li2ui$ations an$ #ailures o# banks an$ corporations'
higher unemployment' an$ a public backlash in #uture elections% =anks are
un$er tremen$ous political pressures to un$erstate the magnitu$e o# the NPA
problem' keep NPAs o## their books' an$ minimi7e the amount o# NPA loan
loss reserves% =anks are unwilling to sell NPAs because they will incur
a$$itional losses /beyon$ their loan loss reserves1 to $ispose o# the loans at
market clearing prices' an$ this in turn coul$ negatively impact their capital
27
a$e2uacy ratios% (hey continue to exten$ payment terms when loans come
$ue an$ to provi$e money to large borrowers to keep their interest payments
current% (heir hope is that Asia9s struggling economies an$ borrowers will
recover an$ make them whole again% In actuality' the problem is getting worse%
=orrowers $on9t want to put goo$ money into trouble$ assets% =anks $on9t
want to #oreclose on the assetsU conse2uently' they have no legal authority to
act as custo$ians to protect the value o# their collateral% (he value o# these
assets continues to $eteriorate' which re$uces the amount the banks coul$
recover when they are eventually #orce$ to #oreclose an$ $ispose o# the
associate$ loans% ?eanwhile' loans tumble $own the classi#ication la$$er #rom
substan$ar$ to $oubt#ul or loss% =ecause governments an$ banks have been
slow to act' the $isposition o# NPAs is moving at a snail9s pace an$ coul$ take
years to complete% In )apan' #or example' since *++,' banks have $ispose$ o#
about :<.. billion o# NPAsU however' they still have :*%- trillion in their
port#olios' or about the same as two years ago%
NPA juris$iction
In some countries government agencies such as the &orean Asset
?anagement "orporation /&A?"81 in &orea or the 6inancial Sector
Restructuring Authority /6RA1 in (hailan$ got o## to a strong start by gathering
the NPAs #rom #aile$ #inancial institutions in their countries an$ o##ering them to
#oreign investors at market clearing prices% 4owever' some borrowers an$
banks $eman$e$ higher prices' which investors re#use$ to pay% (his impasse
le$ to the #ormation o# A?"s to take the ba$ loans #rom banks an$ warehouse
them #or #uture resolution through $isposal' restructuring' joint ventures' or
securiti7ation% Regar$less o# whether NPAs remain with the banks or are
trans#erre$ to the A?"s' they are still NPAs' an$ (hese are not inclu$e$ in the
o##icial estimates%
Impaire$ loans
An impaire$ loan is one in which the len$er must assess the borrower9s ability
to repay the loan when it comes $ue% I# the loan cannot be re#inance$' then the
len$er must look to the borrower9s balance sheet to $etermine i# the borrower
has su##icient li2ui$ assets to repay the loan% I# the borrower9s assets are all
tie$ up in the business' an$ the borrower has insu##icient resources to repay
the loan in #ull when it becomes $ue' the loan is impaire$% (his re2uires banks
3!
an$ regulators to classi#y it accor$ing to loan classi#ication stan$ar$s in each
country an$ to set asi$e appropriate loan loss reserves% 4owever' the process
o# i$enti#ying impaire$ loans is extremely complex an$ time3consuming% It
re2uires the #inancial institution an$ bank regulators to make a series o#
complex ju$gments about the borrowers9 business prospects' estimates o#
cash #low' an$ valuation o# the market value o# the collateral' an$ to assess the
strength o# the guarantor /i# there is one1 an$ weigh many inter3relate$ #acts to
arrive at an appropriate loan classi#ication an$ loan loss reserve% Mn#ortunately
in Asia' there are #ew people within the banks an$ government agencies with
the experience an$ expertise to assess an$ evaluate all o# these complex
#actors% 6urthermore' banks are o#ten skeptical that trouble$ borrowers are
provi$ing them with reliable in#ormation on which to make these ju$gments% A
look at the in$ivi$ual regions that constitute much o# the market #or NPAs in
Asia o##ers insights into how each #inancial system is $ealing with the NPA
problem' how much progress has been ma$e' what lessons have been
learne$' an$ what steps nee$ to be taken to resolve the problem%
0ata on NPA levels in certain Asian countries is given in (able G A $i##erent
picture is obtaine$ when NPAs are compare$ across $i##erent Asian countries%
(here $oes appear to be consi$erable variation in the levels o# NPAs in these
countries% (he table gives the @atest position o# NPAs in these countries' which
is < years a#ter the Asian crisis% 4ence' while there9ll be the in#luence o# the
crisis even now' the perio$ is su##iciently long to have the reme$ial measures
have an impact on the system% In a comparative context' the level o# NPAs in
In$ia is reasonably low% In$ia9s NPA levels are very reasonable compare$ with
the other Asian countries% (he me$ian value #or these countries is aroun$
**%-O% 4owever' there woul$ be V$e#inition9 $i##erences between these banks
as most countries $o #ollow the *32uarter norm #or recogni7ing a NPA%
31
(able G 3 NPAs in Asian "ountries! -...
"ountry NPA Ratio /O1
Australia *%.
Singapore *%.
4ong &ong F%G
In$ia N%.
(aiwan N%,
&orea **%-
?alaysia *-%.
)apan *N%.
Philippines *,%.
(hailan$ *5%.
In$onesia -N%.
"hina -5%.
Source! Asia Ieek /Ieb site1
(he table also shows that the "hinese banks are plague$ with higher level o#
NPAs' #ollowe$ by banks in In$onesia' (hailan$' Philippines an$ )apan%
Singapore an$ Australian banks have the lowest ratios o# NPAs in the systems%
(he NPA levels have gone up $ue to the slump in the I( in$ustry an$ the other
export oriente$ in$ustries which have been a##ecte$ by the recession in the
MSA% =ank loans have also been a##ecte$ by the state o# the consumer goo$s
markets as retail loans $o have a relatively higher share in the total loan
port#olio o# banks in countries like 4ong &ong%
Intensities o# crises an$ the associate$ problems o# non3 per#orming assets
have been $i##erent in $i##erent countries% In )apan the problem o# NPAs is
most severe% currency collapse an$ banking crisis in In$onesia' &orea
?alaysia' (hailan$ an$ Philippines $uring secon$ hal# o# *++, #urther
worsene$ NPAs o# )apanese banks% @et us see the various $e#initions o# Non3
Pe#orming Assets%
In In$ia an asset is Non Per#orming i# interest an$ the installments o# principle
amount $ue remain unpai$ #or more than *5. $ays%
international comparison o# $e#initions!
W Iin$onesia33 a loan asset is classi#ie$ as a Non Per#orming asset i# repayment
o# loans in arrear is possible between < to N months
W &orea33 a Non Per#orming asset is $e#ine$ as an asset which is covere$ by
collateral but borrowers cre$it3 worthiness are $eteriorating an$ payments are
more than N months past $ue
W Philippines33 loans that involve a substantial $egree o# #uture loss without any
speci#ication o# waiting perio$ are terme$ as Non Per#orming asset
32
,%* NPAs in In$ia ! An 8verview
A#ter nationali7ation' the initial man$ate that banks were given was to expan$
their branch network' increase the savings rate an$ exten$ cre$it to the rural
an$ Small Scale In$ustry sectors% (his man$ate has been achieve$ a$mirably%
Since the early +.9s the #ocus has shi#te$ towar$s improving 2uality o# assets
an$ better risk management% (he $irecte$ len$ing approach has given way to
more market $riven practices%
(he Narasimhan "ommittee has recommen$e$ pru$ential norms on income
recognition is now not on an accrual basis but when it is actually receive$%
Past problems #ace$ by banks were to great extent attributable to this%
"lassi#ication o# what an NPA is has change$ with tightening o# pru$ential
norms% "urrently An asset is non per#orming i# interest an$ installments o#
principal $ue remain unpai$ #or more than *5. $ays%
,%*%* 8verview o# Per#ormance
(here have been noticeable improvements in the #inancial health o# the banks
in terms o# asset 2uality% 6urther' pre an$ post re#orm NPA levels are not
strictly comparable as there has been a signi#icant tightening o# accounting
norms%
33
=ase$ on Aross an$ Net NPAs 3 (able N
Aross NPAs Net NPAs
Kear Aross
Amount
/Rs% "rore1
NPAs
As a Percentage
o# total a$vances
Amount
/Rs% "rore1
As a percentage
o# total a$vances
*++-3+< <+-G<%*F -<%*5 No 0ata
*++<3+F F*.F*%<< -F%,5 *+N+.%,F *F%FN
*++F3+G <5<5G%*5 *+%FG *,GNN%NF *.%N,
*++G3+N F*NN.%+F *5%.* *5-+,%F+ 5%+
*++N3+, F<G,,%.+ *,%5F -.-5F%,< +%*5
*++,3+5 FGNG-%NF *N%.- -*-<-%*< 5%*G
*++53++ G*,*.%G *G%5+ -F-**%F+ 5%*<
*+++3-... G<-+F%.- *F%.- -N*5,%N ,%F-
-...3.* GF,,<%*N *-%F -,+N5%** N%,F
Source! ?uniappan A%P% /-..-b1
(he ratios o# both have been constantly improving%
It is generally #elt that the NPA level in In$ia remains high by global stan$ar$s
even though it has been coming $own over the years% 6urther' the $e#inition o#
NPAs in the In$ian context is certainly more liberal with the -32uarter norm
being applie$ #or classi#ication o# such assets% (he R=I is moving over to the *3
2uarter norm #rom -..F onwar$s' an$ hence' banks nee$ to be prepare$ #or a
phase$ movement over to this new classi#ication norm% Such reclassi#ication
woul$ necessarily mean higher level o# NPAs in #uture%
NPAs base$ on @oan @oss Provisioning
(he net NPAs F have continually $ecline$ #rom *F%FNO in *++<3+F to N%,FO in
-...3.*% R=I regulations re2uire that banks buil$ provisions upto at least a
level o# G.O o# their gross NPAs% (he current provisioning is <GO o# gross
NPAs%
,%*%- Sector Iise "lassi#ication o# NPAs in In$ia
As can be seen #rom (able ,' the main culprits are not the priority sectors or
PSMs' but are thr large in$ustries% I# government sops to agriculture an$ Small
Scale In$ustry sectors are exclu$e$' the NPAs in the priority sector are even
lower%
34
(able ,
=orrowing Segment3wise
0istribution o# Aross NPAs
Aross NPAs on <*
St
?arch -..-
Amount /RS%"rore1 Percentage o#
(otal NPAs
Public Sector Mnits *<<F%.G -%FF
@arge In$ustries **F+5%* -.%++
?e$ium In$ustries 5NG5%N+ *G%5*
8ther Non3Priority Sectors +G*N%N- *,%<,
Agriculture ,<**%F *<%<G
Small Scale In$ustries *.-5F%+, *5%,5
8ther Priority Sectors N*N+%<< **%,-
Q! Exclu$es regional rural banks
Source! ?uniappan A%P% /-..-b1
,%*%< "auses o# the NPAs problem in In$ia
(he NPA problem in In$ia is attribute$ not to lack o# strict pru$ential norms but
*% (he legal impe$iments an$ time consuming nature o# asset $isposal
process%
-% Postponement o# the problem in or$er to report higher earnings
<% ?anipulation by the $ebtors using political in#luence
A perverse e##ect o# the slow legal process is that banks are shying away #rom
risks by investing a greater than re2uire$ proportion o# their assets in the #orm
o# sovereign $ebt paper%
,%*%F ?easures a$opte$ to resolve NPAs problem in In$ia
NPA 8r$inance!
(he government recently enacte$ the Asset Reconstruction 8r$inance to try
an$ tackle the Problem% It gave wi$e powers #or the banks to $ispose o## NPAs
an$ allowe$ creation o# Asset Reconstruction "ompanies #or this Purpose% (he
securitisation an$ reconstruction o# #inancial assets an$ en#orcement o#
security interest or$inance' -..-' has en$owe$ banks' #inancial institutions'
asset reconstruction companies an$ securitisation companies with
unprece$ente$ powers to take over the management o# a $e#aulting company
or take possession o# the mortgage$ assets o# loan $e#aulters' un$er police
escorts i# $eeme$ necessary% It also largely obviates any role o# the =oar$ #or
In$ustrial an$ 6inancial Reconstruction /=I6R1 as well as court intervention in
recovery o# outstan$ing $ues in the #inancial sector%
35
R=I 0ea$line on NPAs #or Mnits with (ime 8verruns!
In a move that will compel banks to classi#y a larger portion o# their project
#inance port#olio as ba$ loans' R=I has #ixe$ $ea$lines #or recognising projects
with time overruns as non3per#orming assets% Mntil now a project loan was
consi$ere$ to have gone ba$ only i# there were $e#aults in repayment a#ter
completion o# the projects% =anks' there#ore' coul$ continue to show project
loans as stan$ar$ assets $espite $elin2uencies in repayments' by merely
exten$ing the $ate o# completion% In a circular to all banks' R=I sai$ that
project #inance assets can be treate$ as a stan$ar$ asset #or a perio$ not
excee$ing two years beyon$ the $ate o# completion o# the project' as originally
envisage$ at the time o# initial #inancial closure% 6or #ixing the new $ea$lines'
R=I has classi#ie$ projects into three categoriesU "ategory I where projects
ha$ achieve$ #inancial closure which was #ormally $ocumente$' "ategory II
where the projects have been sanctione$ be#ore *++, an$ the original cost o#
project was Rs% *.. crore or more where #inancial closure was not
$ocumente$% "ategory III comprises o# projects sanctione$ be#ore *++, where
the original project cost is below Rs% *.. crore an$ #inancial closure was not
$ocumente$% R=I has sai$ that #or category II projects' where the $ate o#
#inancial closure has not been #ormally $ocumente$ an in$epen$ent group has
been constitute$%
Ihile the ratio o# NPAs has been coming $own over the years' a major
concern is the absolute value o# the gross NPAs% 4igh gross NPAs necessitate
higher provisions' which re$uce pro#its% In #act' in -...3.*' the a$$itions to
gross NPAs were Rs *+'.G*cr' o# which there were recoveriesH re$uctionsH
write3o##s o# Rs *G'NN- cr%
36
,%- NPAS in 8ther Asian "ountries
"hina
Accor$ing to @ar$y' while the 2uality o# the assets o# "hinese #inancial
institutions has $eteriorate$ an$ is now at levels #ar higher than reporte$ by
#inancial institutions in (hailan$ an$ &orea prior to the onset o# the Asian
#inancial crisis
F
in *++,% (he lesson o# the *+5.s is that #inancial $istress is
likely to become systemic when nonper#orming loans' net o# provisions' reach
*G percent o# total loans% In "hina' nonper#orming loans appear to have
reache$ at least -G percent% NPAs1 were categorise$ into Vover$ue9' V$oubt#ul9
an$ Vba$9% (he international stan$ar$ metho$ /Vmention9' Vpass9' Vspecial
mention9' Vsubstan$ar$9' V$oubt#ul9 an$ Vloss91 was only intro$uce$ at the
beginning o# *+++% Existing estimates' by both scholars an$ o##icials' suggest
that' be#ore the East Asian crisis' the bank con$itions in "hina were no better
than those in the crisis3a##ecte$ economies% (he average capital a$e2uacy
ratio o# the #our pillar S8=s was only F%F per cent' lower than 5 per cent
re2uire$ by the =ank o# International Settlement an$ "hina9s own commercial
bank law% ?ost o# the banks ma$e losses #rom *++N i# uncollecte$ receivable
interest payments were exclu$e$ #rom their #inancial accounts% (he proportion
o# NPAs was estimate$ at -F3-N per cent' higher than that in (hailan$' &orea'
In$onesia an$ ?alaysia% (he proportion o# ba$ $ebts was at least N per cent'
in$icating that these banks were technically insolvent%
A#ter the crisis began' the "hinese government recapitalise$ the #our major
banks' through issuance o# treasury bon$ o# R?=-,. billion' raising their
capital a$e2uacy ratio to 5 per cent% (he ba$ loan problem' however'
worsene$% Accor$ing to conservative estimation' the proportion o# NPAs is now
above <. per cent% (his was' again' supporte$ by recent enterprise survey
$ata on non3per#orming $ebts%
Increases in NPAs in "hina were closely associate$ with the evolving
triangular relation between the state bu$get' the state3owne$ enterprises
/S8Es1 an$ the state3owne$ banks /S8=s1 $uring the re#orm perio$%
4
e%er B8s C#ina sta6$e -D 6y 0% Shambaugh% ?%E% Sharpe' Armonk' New Kork
32
In pre3re#orm "hina' S8Es were run as workshops o# the state economy T
with all the inputs supplie$' output took away an$ #inancial accounts
automatically balance$% (he state bu$get was the major collector an$
$istributor o# capital% (he monobank system only playe$ a limite$ role in
allocation o# a small proportion o# working capital%
(he objectives o# re#orm were #or the state bu$get to retreat #rom accounting
#unctions #or enterprises an$ to #ocus on public goo$ activities' the bank
system to become the major allocator o# capital accor$ing to market rules' an$
the enterprises to per#orm e##iciently%
(he Vloan #or grant9 an$ Vtax #or pro#it9 re#orms cause$ $ramatic rise o# the
S8Es9 $ebt3to3e2uity ratio' #rom -< per cent in *+5. to FF. per cent in *++5%
(he enterprise re#orms succee$e$ in expan$ing autonomy an$ improving
incentives but #aile$ in e##ectively en#orcing market $isciplines% (he ol$ Vso#t3
bu$get9 problem evolve$ into Vautonomy without $iscipline9 phenomenon%
6alling e##iciency an$ over3spen$ing behaviour eventually ma$e the state
sector a net loss3maker #rom *++N% (his $irectly resulte$ in accumulation o#
ba$ loans%
(he state bu$get9s capacity to raise revenue $ecline$ signi#icantly $uring the
re#orm perio$' with the share o# #iscal revenue in A0P #alling #rom above <.
per cent in the early *+5.s to aroun$ *- per cent in the late *++.s% (he
government' however' coul$ not retreat completely #rom economic activities'
inclu$ing subsi$ising the loss3making S8Es% It thus turne$ to banks #or
#inancial resources through policy loans% In the *++.s' the policy loans
accounte$ #or <G3F. per cent o# total bank loans% Projects #inance$ by the
policy loans usually ha$ high $e#ault rates% 6inally' the S8=s su##ere$ #rom the
usual problems o# the S8Es' such as lack o# market $isciplines an$ slack o#
managers an$ employees% =ank managers were appointe$ by local
governments an$ #oun$ it impossible to reject state interventions% In *++5' #or
instance' all the commercial bank managers were calle$ to help achieving the
macroeconomic objectives% =anks9 len$ing $ecisions lacke$ risk assessment%
Recent survey $ata on S8Es show that there existe$ no $i##erence in terms o#
rejection rates an$ si7es o# approve$ loans by S8Es between the pro#itable
an$ loss3making #irms%
38
(he "auses behin$ NPA problem are summerise$ as un$er!
?oral 4a7ar$! (he S8Es believe that there the government will bail them out
in case o# trouble an$ so they continue to take high risks an$ have not really
strive$ to achieve pro#itability an$ to improve operational e##iciency%
=ankruptcy @aws! =ankruptcy @aws in "hina #avor borrowers an$ law courts
are not reliable en#orcement vehicles%
Political an$ Social Implications! Political an$ social implications o#
restructuring S8Es #orce the governments to keep them a#loat%
=anks are reluctant to len$ to the private enterprises $ue to
a% Non3stan$ar$ Accounting Practices
b% Ihile A NPA o# a S8E is #inancially un$esirable' a NPA o# a Private
enterprise is both #inancially an$ politically un$esirable%
?easures
Re$ucing Risks by strengthening banks' raising $isclosure stan$ar$s
an$ spearhea$ing re#orms o# the S8Es by re$ucing their level o# $ebt%
@aws were passe$ allowing the creation o# Asset management
companies' #oreign e2uity participation in securitisation an$ asset bake$
securitisation%
(he government bore the #inancial loss o# $ebt $iscounting%
0ebtH E2uity swaps were allowe$ in case a growth opportunity existe$%
Incentives like (ax =reaks' exemption #rom a$ministration #ees an$
clear cut asset evaluation norms were implemente$%
(hailan$
"auses behin$ NPA problem
@iberlise$ "apital an$ "urrent AHc ! @iberlise$ capital an$ current accounts an$
external borrowings with inaccurate assessment o# exchange rate risk an$ risk
o# capital #light in a crisis%
A legal system tthat ma$e cre$it recovery time consuming an$ $i##icult%
37
Real Estate Speculators! (hey took massive loans projecting high growth in
$eman$ an$ prices o# properties% Ihen such growth $i$ not materiali7e' all the
loans went ba$%
Steep interest rate rise turne$ a lot o# loans into NPAs%
Inability to correctly assess cre$it risk%
?easures
Amen$ments were ma$e to the =ankruptcy Act%
"orporate 0ebt Restructuring A$visory "ommission was set up #or the
takeover an$ restructuring o# banks%
(he #inancial sector Restructuring Plan /*++51 #ocuse$ on capital
support #acilities #or bank recapitalisation an$ setting up o# Asset
?anagement "ompanies%
New rules governing NPA exit proce$ures base$ on international
stan$ar$s were intro$uce$%
Privatisation o# government entities was moote$' but #ace$ strong
political opposition #or #ear o# a social backlash%
A$option o# international stan$ar$s o# loan classi#ication an$
provisioning%
"aps on 6oreign E2uity 8wnership in #inancial institutions were
remove$%
&orea
"auses behin$ the NPA problem
?is3$irecte$ "re$it! Protecte$ perio$s o# interest rate control an$ selective
cre$it allocations gave rise to an ine##icient $istribution o# #un$s% (he "haebol9s
#ocus on increasing market share an$ pursuing $iversi#ication with little
attention to pro#itability cause$ tremen$ous stress on the economy%
@everage$ Expansion in anticipation o# growth! (he compresse$ growth policy
via aggressive' leverage$ expansion worke$ well as long as the economy was
growing an$ the return on income excee$e$ the cost o# capital% (his strategy
back#ire$ when slowing $eman$ an$ rising input costs place$ severe stress
on their pro#itability%
4!
@ack o# ?onitoring! =anks relie$ on collaterals an$ guarantees in the allocation
o# cre$it an$ little attention was pai$ to earning per#ormance an$ cash #lows%
"ontagion E##ects! "ontagion e##ects #rom South East Asia coinci$e$ with a
perio$ o# structural a$justments as well as a cyclical $ownturn in &orea%
?easures
Spee$ o# Action! (he spee$y containment o# systematic risk an$ the
$omestic cre$it crunch problem with the injection o# large public #un$s
#or bank recapitalisation were critical steps towar$s normali7ing the
#inancial system%
"orporate Restructuring Behicles /"RBs1 an$ 0ebtH E2uity Swaps were
use$ to #acilitate the resolution o# ba$ loans%
"reation o# the &orea Asset ?anagement "orporation /&8?"81 an$ a
NPA #un$ to #un$ the purchase o# NPAs%
Securitisation! &8?"89s recoveries came through asset3backe$
securitisation an$ outright sales% International investors like the @one
Star 6un$ participate$ in the process
Strengthening o# provision norms an$ loan classi#ication stan$ar$s
base$ on #orwar$ looking criteria /like #uture cash #lows1 were
implemente$% (he objective o# the central bank was solely $e#ine$ as
maintaining price stability% (he #inancial Supervisory "ommission /6S"1
was create$ to ensure an e##ective supervisory system in line with
universal banking practices%
)apan
"auses behin$ the NPA problem
Investments were ma$e in real estate at high prices $uring the boom perio$%
@ater the recession cause$ prices to crash an$ turne$ a lot o# loans taken #or
investing in real estate ba$%
@egal ?echanisms to $ispose ba$ loans were time consuming an$ Expensive%
Expansionary #iscal policy measures a$ministere$ to stimulate the economy
supporte$ in$ustrial sectors like construction an$ real estate' which may have
#urther exacerbate$ the problem%
41
"rony "apitalism to the &eiretsus%
Ieak corporate governance couple$ with a non3bankruptcy $octrine was a
moral ha7ar$ in )apanese economy%
Ina$e2uate accounting systems an$ in#ormation #low makes assessment o#
loan per#ormance outsi$e a bank in )apan $i##icult%
?easures
Amen$ments 8# 6oreign Exchange "ontrol @aw an$ the threat o#
suspension o# banking business in case o# #ailure to satis#y the capital
a$e2uacy ratio prescribe$% @egislation to improve in#ormation #low has
been passe$%
Accounting Stan$ar$s! ?ajor business groups establishe$ a private
stan$ar$3setting vehicle #or )apanese Accounting Stan$ar$s /-..*1 in
line with the international stan$ar$s%
Aovernment Support! (he government is committe$ public #un$s to
$eal with banking sector weakness%
-. Resolution o" NPAs in the Asian .onte/t
(o un$erstan$ better the reme$ies that can be use$ to resolve the issue o#
NPAs' certain country case stu$ies have been $escribe$ below which show as
to how these nations have tackle$ the issue through the setting up o# Asset
?anagement "ompanies an$ through securitisation% Also the propose$
mo$i#ications in their resolution practices have been $iscusse$ below in $etail%
"hina
(he Asset ?anagement "ompanies
(he Asset ?anagement "ompany /A?"1 is "hina9s main approach in $ealing
with the ba$ loans% =etween April an$ 8ctober in *+++' #our A?"s were
establishe$ #or the #our pillar state commercial banks! "in$a /"onstruction
=ank o# "hina1' 8rient /=ank o# "hina1' 4ualong /In$ustry an$ "ommerce
=ank o# "hina1 an$ Areat Iall /Agricultural =ank o# "hina1% All the A?"s are
$esignate$ to exist #or ten years% (hey mo$elle$ on the Resolution an$ (rust
42
"orporation /R("1 #or $ealing with the ba$ assets o# the #ailing Saving an$
@oan Associations in the *+5.s in the Mnite$ States%
(he management arrangements #or the A?"s are complicate$% (he A?"s are
$irectly responsible #or the ?inistry o# 6inance which not only provi$e$ each o#
them with R?=*. billion initial capital but woul$ also bear the conse2uences
o# A?"s9 per#ormance% Supervision o# the A?"s' however' is the responsibility
o# the central bank% (he actual management is closely associate$ with their
parent banks% 6or instance' "in$a9s employees were mostly trans#erre$ #rom
the "onstruction =ank o# "hina /"="1% (he governor o# the "=" is "in$a9s
Party Secretary an$ a $eputy governor is its "hairman% A primary reason #or
setting up separate A?"s instea$ o# letting banks han$le their own NPAs is
that the "hinese law $oes not allow commercial banks to engage in
investment banking activities%
(he objective o# the A?"s is to maximise recovery #rom the NPAs% (o ensure
this' a bonus scheme is $evise$ #or the employees% (he A?"s trans#er'
manage an$ sell nonper#orming loans an$ assets%
(he #irst step is to trans#er about R?=*... billion NPAs /about hal# o# the total
estimate$ NPAs1 #rom the banks to A?"s% (he parent banks are to be
compensate$ in two ways! /*1 trans#er o# re3len$ing by the central bank #rom
parent banks to A?"s /about F. per cent o# the total trans#erre$ NPAs1U an$
/-1 purchase o# state3backe$ A?" bon$s by parent banks /about N. per cent
o# the total trans#erre$ NPAs1% (he #ormer approach takes both ba$ assets
/NPAs1 an$ liabilities /central bank re3len$ing1 o## the parent banks9 balance
books% An$ the latter approach converts ba$ assets /NPAs1 into goo$ assets
/state3backe$ bon$s1% (he parent banks9 balance sheets are improve$ a#ter
the trans#er% (he A?"s have a$opte$ #our types o# metho$s to $eal with the
NPAs%
(he #irst is to $irectly sell the NPAs in the market%
(he secon$ is to restructure NPAs with other assets trying to make the whole
lot #inancially valuable%
(he thir$ is to securitise the NPAs using the stock market%
An$ the last is to $irectly restructure problem enterprises' particularly their
management' organisation an$ strategy' applying V$ebt3e2uity9 swap%
43
Accor$ing to the initial plan' A?"s starte$ operating as loan recovery
agencies% =ut because o# the V$ebt3e2uity9 swap' they also act like hol$ing
companies% In #act' their activities are similar to those o# the venture capitalists
an$ investment banks%
Establishment o# the A?"s is only the #irst step% (he A?"s #ace a much more
$i##icult task than the R("% (he ba$ assets that R(" ha$ were mainly in the
#orm o# real estates which were easier to be $ealt with than state enterprises9
NPAs o#ten without collateral% R(" operate$ in a well $evelope$ capital market
with innovative #inancial techni2ues% In "hina' the capital market is still in its
primitive state% (his implies that A?"s have to hol$ the NPAs #or a relatively
long perio$% I# they cannot get ri$ o# all the NPAs by the en$ o# the ten3year
perio$' the ?inistry o# 6inance has to either take over the nominal e2uity or
write o## the NPAs% A?"s also have their own institutional an$ skill problems%
(he A?"s are in essence S8=s' it remains to be seen i# they coul$ intro$uce
e##iciency to their own #irms as well as the enterprises un$er their
a$ministration% It is critical to not only eliminate slack o# employees but also
prevent corruptive behaviour% Exactly #or this reason' R("9s strategy was to
get ri$ o# the ba$ assets as #ast as possible% =ut this woul$ not be possible #or
A?"s given the state o# "hina9s capital market% "hina9s A?"s also lack
nee$e$ skills% 6ive months a#ter establishment' "in$a alrea$y ha$ su##ere$
#rom two problems! re$un$ant workers an$ shortage o# skills%
Still a more important challenge #or A?"s is how to stop creation o# new ba$
loans% R(" $i$ not have this problem because when it came in most Saving
an$ @oan Associations were alrea$y bankrupte$ or about to be bankrupte$%
=ut most problem state enterprises in "hina are likely to continue to exist' at
least in the short term% (his raises the 2uestion about the proper relationship
between the parent banks an$ the A?"s% ?ost economists worry about the
moral ha7ar$ problem on the enterprise si$e #ollowing the V$ebt3e2uity9 swap'
there is actually also a moral ha7ar$ problem on the bank si$e% (he current
one3to3one relation is help#ul #or in#ormation sharing an$ collaboration% (his
approach' however' also #osters collusive behaviour an$ inhibits competition
among A?"s% It is har$ to prevent the parent banks #rom using A?"s as their
outlets #or $ealing with #uture NPAs% An alternative option is to $e#ine a clear3
cut $ate' such as )anuary * *+++ when the new accounting system was
44
a$opte$' a#ter that the banks have to take care o# their own new ba$ loans% It
is i$eal to trans#er the problem enterprises9 $eposits together with their NPAs
to the A?"s% 8# course' this woul$ upgra$e the A?"s into #ully operational
banks' with major implications #or "hina9s #uture banking structure%
=eyon$ the A?"s' success#ul resolution o# the ba$ loan problem is con$itional
on breaking the vicious cycle among the state bu$get' the S8Es an$ the
S8=s% (he government shoul$ stop imposing policy loans on commercial
banks' as three policy banks are alrea$y in place% =ankruptcy law an$ other
market institutions shoul$ be #ully en#orceable to e##ectively $iscipline
ine##icient S8Es% Iithin the banking sector' bank institutions must be #urther
improve$ an$ #inancial supervision #urther strengthene$%
&orea
In resolving NPA problems' the &orean government relie$ on a centrali7e$
A?" approach% (he government ha$ in *++,' assigne$ the role o# purchase o#
ba$ loans to the &orea Asset ?anagement "orporation /&A?"81% Also bank
base$ A?"s were create$ #or the sale o# ba$ loans o# two major banks%
&A?"8 was establishe$ in *++N #or the #oreclosure an$ sale o# assets
attache$ to #or tax arrears' the li2ui$ation o# corporations an$ the han$ling an$
$isposition o# government owne$ properties% In *++,' through a special NPA
6un$' &A?"89s role was expan$e$ to inclu$e the purchase o# NPAs to assist
in the rehabilitation o# the #inancial sector% &A?"8 became a ba$ bank an$ a
non3per#orming asset #un$ was create$ to #inance the purchase o# NPAs% (he
government o# &orea' &orea 0evelopment =ank an$ -F banks are joint
sharehol$ers o# &A?"8% ?ost o# its #un$s come #rom bon$s' which are issue$
#or a perio$ o# < years an$ yiel$ a 2uarterly interest applicable to the &orean
0evelopment =ank% (he balance comes #rom the central bank' #inancial
institutions an$ &orea 0evelopment =ank% (he main goal o# the &A?"8 was
to spee$ily $ispose o## NPAs to better the li2ui$ity an$ soun$ness o# the
#inancial institutions' an$ this is to be accomplishe$ by -..<%
(o begin with' &A?"8 pai$ #or the ba$ loans partly in cash an$ partly in bon$s
but #rom *++5 onwar$s it was $one through &A?"8 bon$s% In the past'
&A?"8 ha$ purchase$ NPAs #rom #inancial institutions in batches at #ixe$
amounts up #ront' base$ on the expecte$ recovery value o# the port#olio%
45
&A?"8 ha$ then engage$ in $ue $iligence process on each NPA' a$juste$
the initial price an$ then resettle$ $epen$ing on the nature o# each loan an$
asset% In September *++5' there was a change in the ac2uisition metho$ to a
#ixe$ purchase rate% &A?"8 purchases were exempt #rom ac2uisition an$
registration #ees but this $i$ not carry #orwar$ #or subse2uent purchasers o#
the assets #rom the investor% (he exact calculation o# the purchase rate is
given below in (able 5
(able 5 3 Baluation o# NPAs! (he &orean "ase
8r$inary
NPAs
"urrently in $e#ault making no payment
Secure$
NPAs
Appraise$ value o# collateral /value resulting #rom the latest appraisal by an
in$epen$ent appraisal agency at the re2uest o# courts1 D senior lien amount X
FGO
Mnsecure$
NPAs
Principal amount X <O
Special NPAs 8btaine$ court approval #or restructuring #or the corporate re3organisation
Secure$
NPAs
@oan amount X FGO /#or initial purchase which will be a$juste$ at! present
value o# projecte$ cash #lows X $iscount rate /base rate Pcre$it risk P maturity
risk1
Mnsecure$
NPAs
Principal loan amount X <O
&A?"8 ha$ planne$ recoveries though asset3backe$ securiti7ation schemes
or outright sales or workout schemes% In a 0ecember *++5 auction' (exas
base$ @one Star 6un$ purchase$ I GNG bn #or I-.* bn /a NFO $iscount1
#rom &A?"8% &A?"8 ha$ ac2uire$ the $ebts collaterali7e$ by *G.. houses'
buil$ings an$ #actories #rom #inancial institutions #or I-.F bn%
&A?"89s strategies #or recovery were $ebt restructuring /partial $ebt
#orgiveness' amen$e$ terms an$ $ebt3e2uity swaps1' outright sales /loans sol$
in$ivi$ually or package$ in port#olios an$ o##ere$ to investors1' asset3backe$
an$ e2uity partnerships securities% (hese assets were trans#erre$ to a SPB
trust' which in turn issue$ $ebentures an$ bon$s to be sol$ to institutional
investors% &A?"8 also went in #or #oreclosure auctions where they coul$
$ispose o## the assets through court auctions an$ asset restructuring% &A?"8
ha$ issue$ "@8s an$ ?=Ss using the assets bought #rom banks an$
properties obtaine$ through exercising collateral rights% (hese "@8s were
46
guarantee$ by &A?"8 an$ carrie$ a put option to sell the loan assets back to
the banks in case the loan #ell into $e#ault%
In November -...' the &A?"8 carrie$ out its #irst international securiti7ation
o# NPAs' an$ was the #irst one $one with a NPA in &orea% (his involve$ the
establishment o# two special purpose vehicles' one in &orea an$ the other in
"ayman Islan$s% &A?"8 sol$ a static port#olio o# NPAs in MS $ollars an$
yens to the &orean SPB% (he &orean SPB issue$ notes' which were
purchase$ by the "ayman SPB% (he "ayman SPB in turn issue$ notes
secure$ on amongst other things' the &orean SPB notes an$ NPAs% (he
&orean SPB' &orea *st International A=S Specialty "o was incorporate$ as an
o##3balance sheet limite$ liability company% Each NPA is the subject o# a
settlement agreement ma$e between &A?"8 an$ the &orean commercial
bank #rom which it originally purchase$ the relevant NPA% Each settlement
agreement contains an option' which allows &A?"8 to put an NPA back to the
selling bank on the occurrence o# certain events such as a payment $e#ault in
respect o# the NPA continuing #or six months or longer% (he NPAs an$ the
settlement agreements were trans#erre$ to the SPB un$er a loan port#olio
trans#er agreement governe$ by &orean law% &A?"8 is responsible #or
exercising the put options with the &orean banks on behal# o# the &orean SPB%
(he &orean SPB issue$ senior an$ subor$inate$ notes' the procee$s o# which
comprise$ the purchase price o# the NPAs% (he security #or the senior note
inclu$e$ a &orean law ple$ge over the NPAs% In a$$ition to the subor$inate$
note' #urther cre$it enhancement #or the senior notes was provi$e$ by way o#
an irrevocable cre$it #acility #rom the &orean 0evelopment =ank to the &orean
SPB in respect o# amounts payable un$er the &orean SPB senior note%
&orean regulation prohibits re$emption o# principal until a#ter the #irst
anniversary o# the issue $ate o# the senior note%
(he &orean SPB senior note was sol$ to the "ayman SPB' &orea Asset
6un$ing -...3* @imite$' which in turn issue$ #loating rate notes% (hose notes
are secure$ on amongst other things' the "ayman SPB9s interest in the
&orean SPB senior note% (hese senior notes are rate$ ===P an$ =aa- by
6itch an$ ?oo$y9s an$ are liste$ on the @uxembourg Stock Exchange% (hey
were o##ere$ to 2uali#ie$ institutional buyers in the MSA pursuant to Rule *FFA%
42
(hailan$
(he 6inancial Sector Restructuring Agency /6RA1 was establishe$ to resolve
the issue o# NPAs% It was success#ul in selling o## assets that were easy to
value such as physical assets% (hey were sol$ at an average o# G.O o# book
value% 4owever' the sale o# corporate loans with a #ace value o# over Rs *. bn
$i$ not attract too many bi$$ers% 8nly *- banks took part in this exercise an$
most o# them were below what the authorities regar$e$ as the minimum
acceptable value o# -G3<.O o# book value% 4owever' at a later $ate about a
thir$ o# the assets were sol$ at -*O o# the #ace value plus a pro#it sharing
$eal%
)apan
6or )apan "@8s represent an opportunity to re$uce ba$ loans on the balance
sheets which' will enable them to meet the =IS capital a$e2uacy norms% Ihen
loans are hel$ an$ not securiti7e$' )apanese banks must retain capital e2ual
to 5O o# the port#olio% 4owever' by removing them #rom the balance sheet
through "@8s' capital re2uirement #alls to the level o# e2uity retaine$ by the
bank% 6or example' i# the bank retains a <O stake in the "@8' then the capital
re2uirement is only <O /*..O o# the <O stake1 instea$ o# the 5O re2uirement
by =IS stan$ar$s% 4owever' securiti7ation remains a less3utili7e$ tool o# NPA
resolution in )apan' ostensibly $ue to legal' tax an$ cultural restrictions /4err
& ?iya7aki' *+++1%
(he )apanese banks can sell their NPAs to a jointly establishe$ SPB% (he SPB
coul$ then pool the loans an$ issue A=S% Although the proposal results in
banks9 recogni7ing a loss when they sell the loans that are backe$ by
collateral' the loss woul$ create a tax shiel$%
(he banks coul$ mix any proportion o# per#orming an$ non3per#orming loans
$epen$ing on market $eman$% (his helps banks to remove loans #rom their
balance sheet an$ they $erive a tax bene#it% Also the government is relieve$
#rom the job o# using public #un$s to subsi$i7e banks% 6or example a bank A
can have a book value o# a loan o# *..' which has a collateral value o# N.% (his
amount is then to be sol$ to the SPB with a loan o# N. being simultaneously
ma$e to the SPB' an$ the bank A gets a tax bene#it on the loss o# F. that is
shown in the books% (he SPB alternatively coul$ issue A=S an$ pay #or the N.
48
#rom =ank A% (he SPB can sell the collateral but that coul$ $epress the
markets #urther an$ hence the value o# the collateral% (here#ore' the proposal
here is that the SPB pool all the loans an$ issue A=Ss an$ use the procee$s
#rom the sale o# properties as collateral or as cash #low% (he sale o# loans to
the SPBs $elinks the loans #rom the banks an$ the rating o# the A=S will be
base$ on that o# the SPB' whose only assets are the pool o# properties% (here
is lack o# enthusiasm #or investors in the )apanese market' as there is the risk
o# non3payment o# interest by the SPB $ue to insu##icient income #rom the
properties% (he SPB shoul$ hence' have some kin$ o# insurer involve$ to take
care o# the interest payment or alternatively the government can provi$e the
cre$it enhancement% Yero coupon bon$s issue$ woul$ also be e##ective as the
perio$ is elongate$%
(he A=S coul$ be issue$ in senior' junior an$ subor$inate portions varying by
the amount o# the government9s guarantee% Say' 5.3*..O o# the senior notes
can be guarantee$ while only G.O o# the junior portion may be guarantee$%
(he percentages will vary $epen$ing on the 2uality o# the pool' the proportion
o# per#orming loans an$ NPAs' government level o# participation etc% (he SPB
coul$ enter into a swap agreement with a counter party to he$ge against
currency an$ or interest relate$ risk% (he a$vantages o# this proposal are that
there will be an increase in li2ui$ity' investor base an$ boost to the property
market% ?ore banks coul$ enter this scheme' which have staye$ away so #ar%
(he Euro market has been a #avourable market #or the senior portion o# the
A=S% (he Euro market woul$ also be intereste$ in the junior market in case
the returns are ma$e attractive% MS investors were the target group #or the
subor$inate portion%
0. .o%1arati&e Analysis o" NPA 1ro2le% 3 resolution
in India and other Asian .ountries.
+%* Similarities between NPA problem in In$ia an$ other Asian countries
47
In#ormation Cuality
@ee an$ Ahn argue that the capacity o# the institutional governance
environment to generate a transparent in#ormation base is integral to e##icient
#inancial sector $evelopment% An in$ex o# in#ormation 2uality is use$ to
evaluate the relative strengths o# #inancial systems% 8n the aggregate
in#ormation 2uality scale ranks were In$ia /F*
st
1' "hina /F,
th
1' &orea /-.
th
1'
(hailan$ /<-
n$
1' an$ )apan /+
th
1 out o# GG countries% (he structural strength o#
banks is relevant as it inclu$es measures o# accounting stan$ar$s' $e#inition
an$ provisioning o# NPAs an$ the 2uality o# management% (he scores in this
category were In$ia /*%,1' "hina /-1' &orea /<%+1' )apan /G%*1 an$ (hailan$
/<%G1%
@egal Systems!
All the Asian countries ha$ weak legal mechanism #or asset $isposal% (his
#actor prevente$ the early resolution o# the problem%
Aovernments 6un$s!
All the countries ma$e extensive usage o# government guarantees an$ #un$ing
to try an$ solve the problem% 8n the #lip si$e' the problem was create$ $ue to
the belie# that the government woul$ have to bail out the banks in a crisis%
+%- 0i##erences between NPA problem in In$ia an$ other Asian countries
"auses o# Problem! (his varie$ signi#icantly across the countries in Asia
with real estate speculations' crony capitalism' mis$irecte$ cre$it an$
the lack o# pru$ential norms being critical #actors%
=usiness Structures! Structures like &eiretsus an$ "haebols in )apan
an$ &orea an$ S8Es in "hina were responsible #or their country9s NPA
problem%
?acroeconomic an$ 6iscal Policy! In$ia an$ "hina were relatively
una##ecte$ by the East Asian "risis $ue to the close$ capital AHc an$
strong $omestic savings% (his prevente$ the conta$ion e##ect #rom
sprea$ing in these two countries% In )apan' the government9s =ig =ang
spen$ingt approach to pulling the country out o# recession may have
en$e$ up creating even more NPAs%
5!
14. .onclusion5 6essons "or E""ecti&e Resolution o"
NPAs
In the prece$ing parts o# this project report' the causes behin$ huge NPAs an$
the resolution techni2ues that have been a$opte$ so #ar in In$ia an$ F other
Asian countries are analy7e$% =ase$ on this analysis' I have trie$ to conclu$e
with some important lessons #or e##ective resolution o# NPAs in banks'
especially in the context o# In$ia% (hese lessons are explaine$ as un$er!
0on9t Eliminate D ?anageZ
Stu$ies have shown that management o# NPAs rather than elimination is
pru$ent% In$ia9s growth rate an$ bank sprea$s are higher than that in western
nations% As a result we can support a non 7ero level o# NPAs which =alances
the risk vis3[3vis return appropriate to the In$ian "ontext%
E##ectiveness o# AR"s
"oncerns have been raise$ about the relevance o# Asset Restructuring
"ompanies /AR"s1 to In$ia% A signi#icant percentage o# the NPAs o# the public
sector banks in In$ia are in the priority sector% @oans in rural areas are $i##icult
to collect an$ banks by virtue o# their sheer reach are better place$ to recover
these loans% @ok A$alats an$ 0ebt Recovery (ribunals are other e##ective
mechanisms to han$le this task% AR"s shoul$ #ocus on the large borrowers%
6urther' there is a nee$ #or private sector an$ #oreign participation in the AR"s%
Private parties will look to active resolution o# the NPA problem an$ not merely
regar$ it as a book transaction% ?oving NPAs to an AR" $oes not get ri$ o# the
problem% In "hina' potential investors are still worrie$ about the risks o# non3
en#orcement o# ownership rights o# the assets they purchase #rom the AR"s%
Actions an$ measures have to be taken to buil$ investors9 con#i$ence%
Iell30evelope$ "apital ?arkets
Numerous papers have stresse$ the criticality o# a well3$evelope$ capital
market in the restructuring process% A capital market brings li2ui$ity an$ a
mechanism #or write o## o# loans% Iithout this a bank may seek to postpone the
NPA problem #or #ear o# capital a$e2uacy problems an$ resort to tactics like
evergreening% ?onitoring by bon$hol$ers is better as they have no motive to
sustain uneconomic activity% 6urther' the banks can manage cre$it risk better
51
as it is easier to sell or to securities loans an$ negotiate cre$it $erivatives%
In$ian $ebt market is relatively un$er$evelope$ an$ attention shoul$ be
#ocuse$ on buil$ing li2ui$ity an$ volumes%
"ontextual 0ecision ?aking
Regulations must incorporate a contextual perspective /like temporary cash
#low problems1 an$ clients shoul$ be han$le$ in a manner' which re#lects true
value o# their assets an$ #uture potential to pay% (he top management shoul$
$elegate authority an$ back $ecisions o# this kin$ taken by mi$$le level
managers%
Securitisation
Securitisation has been use$ extensively in "hina' )apan an$ &orea% (he
securitisation as a business process has attracte$ international participants
$ue to lower li2ui$ity risks% (he Resolution (rust "orporation has helpe$
$evelop the securitisation market in Asia an$ has taken over aroun$ : FN.
billion as ba$ assets #rom over ,G. #aile$ banks% Its highly stan$ar$i7e$
pro$uct appeals to a broa$ investor base% Securitisation in In$ia is still in a
nascent stage but has potential in areas like mortgage backe$ securitisation%
I"RA estimates the current market si7e #or securitisation to be aroun$ Rs%<...
"rores%
E##ects o# "apital Norm (ightening
(his is a #ear that $isposal o# NPAs through the provision o# excessive
reserves may result in a $e#lationary spiral% A thorough provision o# reserves
will have no negative impact on the long term $ivi$en$s pai$ to sharehol$ers%
6irstly' it helps restore cre$ibility in the #inancial system% 6urther' an a$justment
mechanism can be create$ by which the capital gains an$ #uture pro#its that
will result #rom the $isposal o# NPAs will pass back to the cre$itors an$ the
taxpayers who incurre$ the losses to$ay% (he swi#t $isposal o# NPAs $uring the
great $epression in the mi$$le o# a severe $e#lationary current helpe$ restore
the cre$ibility o# the #inancial system%
Realignment o# Per#ormance ?etrics
(ra$itional per#ormance measures like R8E an$ NPA ratio are not really
in$icative o# per#ormance% (hat is ' a high volume o# ba$ len$ing to$ay will
impact positively on R8E' asset growth an$ NPA ratio an$ only show up G
years later as NPAs% Economic Balue o# E2uity /EBE1 /or market value1 an$
52
Economic Balue 8# E2uity at Risk /EBER1 are use#ul mechanisms to han$le
this problem% EBE is the value o# the #irm i# its assets are instantaneously
li2ui$ate$ /assuming the availability o# li2ui$ asset markets1% =ook value vis3[3
vis EBE when compare$' give an i$ea o# whether the #air value is being
re#lecte$% EBER can be compute$ by using VIhat I#9 scenario like $owngra$ing
the ratings o# assets or changing interest rates% Now' at every stage banks can
check i# their actions are consistent with the goal o# maximi7ing EBE' subject
to an acceptable level o# EBER%
"onsistency o# Purpose
Nachiket ?or has argue$ that the current organi7ational competencies'
regulatory #ramework' 2uality o# $isclosure an$ incentive structure
pro$uce an inconsistent #ramework which lea$s to an unsustainable
per#ormance level #or a bank% ?icro level issues will have to be
a$$resse$ in or$er to root out the NPA problem% Processes at every
stage o# an asset9s li#e impact the overall 2uality o# the interme$iation
process an$ so a consistent set o# proce$ures are necessary to
han$le the problem%
@egal Issues
(hey have been instances o# banks exten$ing cre$it to the $oubt#ul $ebtors
/who will#ully $e#ault on $ebts1 an$ getting kickbacks #or the same% Ine##ective
legal mechanisms an$ ina$e2uate internal control mechanisms have ma$e
this problem grow% Cuick action has to be taken on both the counts so that
both the $e#aulters an$ the authori7ing o##icer are punishe$ heavily% Iithout
this step' all the mechanisms suggeste$ above may prove to be ine##ective%
"onclusion! (he project report' there#ore proposes that the soun$
un$erstan$ing o# the institutional variables' macroeconomic variables an$
systematic issues pertaining to banks an$ the economy is re2uire$ in or$er to
solve NPA problem along with the criticality o# a strong legal an$ #ramework
an$ regulatory #ramework% 6oreign experiences in this regar$ must be utili7e$
along with a clear un$erstan$ing o# local con$itions to create an e##ective
customi7e$ solution to NPA problem%
53
=ibliography
Papers
?uniappan A%P% /-...b1 (he NPA 8verhang3 ?agnitu$e' Solutions'
@egal Re#orms;
&ang' ?oon3Soo /-..*1 6inancial Restructuring in &orea; &orea
0evelopment Institute 8ctober -..*%
@ee' )ames "han an$ Ahn Sanghoon /-..*1 In#ormational Cuality o#
6inancial Systems an$ Economic 0evelopment! An In$icators Approach
#or East Asia; A0= Institute working paper -.' )une -..*%
Samaresh =ar$han an$ Sugata ?arjit /-..*1 Non Per#orming Assets o#
In$ian "ommercial =anks! An Analytical Exercise;
?or Nachiket an$ =havana Sharma /-..-1 Rooting 8ut Non3
Per#orming Assets; I"I"I Research Paper' ?arch -..-
?ulye' Sharma' Sabnavis /-..-1 Baluation o# NPAs; I"I"I Research
Paper' ?arch -..-
Xing3Ki Iang /-..*1 (he appreciation o# "hina9s Non3Per#orming
@oan an$ the 8peration o# the capital market;' "hina Areat Iall Asset
?anagement "orporation%
0%Shambaugh' ?%E% Sharpe' Armonk' New Kork% Is "hina StableJ;
@ar$y 0%"% /*++51 I?6 @ea$ing In$icators o# =anking "risis! Is Asia
0i##erentJ;%
Iebsites
www%rbi%org%in
www%a$b%org
www%nber%org
www%iciciresearch%org%
www%im#%org
54
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