REVEALED: What went wrong with bank loans

'Flush with funds, lending became a cash management exercise.'
'Road projects, power generation plants, airports etc were financed left and right with apparently no regard for the projects' ability to repay,' explains S Muralidharan, former managing director, BNP Paribas.
Illustration: Dominic Xavier/Rediff.com

Another day, another dire headline about failing companies, bankruptcies, and banks groaning under the weight of dodgy loans.

Then there are the tabloid stories of the unbelievable lifestyles of errant tycoons who have managed to elude the law here and live in royal luxury elsewhere; and of poorly-paid PSU bank chiefs wrestling with bad loans with one hand tied behind their backs and the referee (read government) making the rules up as they go.

Is this something that is inevitable in a liberal democracy, or are we given to egregiously plundering and thieving public resources?

Some Western critics have even suggested that this is the inevitable result of the 'transactional nature of Hindu culture'.

There are all sorts of diagnoses made of the problem (of bad loans), a few factual, even fewer non-partisan, with none suggesting solutions.

Politics also plays a very big part in the process as it did in the sanction in the first place.

Major parties trade blame when bad loans come to light with the sole intent of throwing in the first handful of mud in the hope that some will stick.

Invariably, truth is the casualty in this political mud slinging. I am surprised to find even a former RBI governor wading in.

Whatever the motives of individual commentators, some facts stand out:

1. There is a big bad loan problem.

2. The problem has reached levels where some banks' viability is under threat.

3. No one has a clue how it happened, nor ideas on how it might have happened other than blaming one dispensation or the other.

4. The political classes do not want to solve the issue, but only keep the pot boiling with 2019 elections in view.

5. A meaningful, dispassionate, and rational analysis (let alone solutions) is beyond the hyperventilating media and their hand-reared talking heads.

Why do we suddenly see so much of bad loans, outright financial frauds and business failures?

Is it all just a matter of reporting by media ever hungry for headlines, or have our society's moral fabric and financial rectitude suddenly taken a turn for the worse?

Are the government's policies to blame, or should the RBI's guidance and supervision of banks carry the can?

Are the bank managements up to their task in a complex, inter-connected and ever sophisticated financial environment?

Is the banking supervisor asleep at the wheel or are the owners and their mandarins interfering in the day-to-day business of the banks?

Do the senior and middle management of the banks have the technical bandwidth to deal with legacy problems and forestall new ones?;

The answer is that the NPA problem is the result of all of these factors.

In such systems, the result of two factors is not simple addition, but exponential.

Any attempt to find a solution based on a simple or simplistic answer is bound to cause the situation to become much, much worse.

In the following paragraphs I shall attempt to parse the issue. I shall only visit the past in order to provide context and only in so far as it helps understand the issue.

To paraphrase George Santayana, 'You can't know where you're going unless you know where you've been.

It is increasingly accepted wisdom in finance that in order to arrive at accurate and actionable diagnoses in the real world, we cannot afford to ignore the behaviour of the people involved.

Behaviours are shaped by millennia of culture, civilisation, traditions, and the balance between collective wisdom and individual will.

Our traditions insisted on meeting our obligations in full and without fail.

For us, the discharge of obligations is a moral imperative, not a contractual requirement. It is absolute, not conditional or contingent. But that was our tradition.

Post the arrival of the East India Company, the moral imperative was replaced by contractual provisos.

During the next three hundred years conscience gave way to contract law. It was no longer necessary to be 'just' or 'fair' or 'straight'; legal liability was all that mattered.

Thus, financial probity meant adherence to the letter of the contract, not to some set of lofty traditional values.

Legality replaced ethics and contract trumped conscience.

Businessmen were quick to spot the opportunities that the new reality presented.

Government ownership created some of the worst distortions in our banking system.

In 1969, ostensibly to fund the development agenda of the government which the privately-owned banks were allegedly loath to toe, 14 banks were 'nationalised'. Suffice it to say the motives were anything but 'clean'.

The floodgates to governmental interference, and political influence were thrown open.

The managements quickly discovered that personal progress demanded pleasing the governments and placating the unions.

Banks continued to open branches left right and centre with little understanding of their new markets and no regard for its viability.

Commercial banks were on an expansion spree throughout the 1970s and 1980s.

Their branch network expanded geometrically while staffing went up exponentially, severely testing the managerial bandwidth of their managements.

The unionised workforce enjoyed political patronage and was often the de facto management.

Labour issues increasingly came to occupy a disproportionate share of management's time and energies, which had to have adversely impacted the core business of banks.

The future management cohort learnt how to 'manage up' rather than how to lend.

Under government ownership it was more important to do things right (procedures) than to do the right things (results).

In other words, 'following procedures' was more important than showing results.

In this atmosphere lending was reduced to a few well-defined steps to be followed, not risks to be divined and controlled.

There were pre-set benchmarks for assessing loan requests which could be met with the help of a halfway decent chartered accountant (and later with MS Excel).

Bank managers had to balance the risk of making 'bad' loans or reject the loan and face the backlash that would ensue.

They usually chose in favour of a 'bulletproof proposal' on paper.

Judging by the situation now, one can conclude that what was then bulletproof on paper is now a dead loan.

In the hands of a savvy businessman one loan can become many.

Although bank loan rules stipulate at least 20% of total requirements of a business must come in the form of 'capital', in point of fact this is hardly ever so.

Through diversions and investments, borrowed funds can be used as capital in another firm where more money can be borrowed against it. This can go on ad infinitum.

The true nature of the diversions can be hidden by adopting a different financial period for each entity.

This, of course, is a simplified version of what goes on.

After the liberalisation of foreign investments, money goes abroad and returns as foreign investments in a company, much like a snake swallowing its own tail.

If you stop this process you will discover a part of the snake is missing!

The government has no incentive to stop it as it gave a false sense of foreign investments into India which it could cite as proof of a policy's success.

The possibility of diverting loans had been observed in the 1960s.

Concerned with its ramifications, the Dehejia committee was set up to examine how to curb such practices whilst meeting industries' genuine needs. This was followed by the Tandon and Chore committees in 1975 and 1980 with the same objectives, but more granular details.

The sum and substance of the recommendations of these three committees was to provide finance for legitimate working capital needs of industry without permitting bank financing for 'hoarding', 'diversion' and 'investments'.

The industries went to work and effectively sabotaged effective implementation using 'salami tactics'.

Instead of fighting these regulations head on, they carved exemptions for their firm, industry, location, etc.

Today, the spirit of these recommendations lies in tatters.

Business houses have grown from a few crores turnover to few tens of billion dollars turnover in just a couple of decades through new investments and acquisitions financed by plain old diversions of bank finances.

One of the ills the Tandon committee foresaw and tried to address was the nature of company borrowings in India.

It uses a 'running account' called cash credit. Essentially it has no repayment date.

Tandon prescribed that increasingly equity capital must finance the core of the working capital, with cash credit only providing the fluctuating part.

The 'salami attack' by industry ensured we never progressed to this stage of the Tandon reforms.

A variation on foreign investment is the acquisition of overseas companies.

Based on a counting trick which inflated our foreign reserves, we allowed Indian companies to invest overseas.

If anyone were to correlate the overseas investments with overseas real estate acquisitions by Indian tycoons, a positive correlation will be found.

Of course, all the acquisitions are by entities based in tax havens whose beneficial owners are unknown, rendering any investigation infructuous.

Another bonus for the business community was the Sick Industrial Companies Act.

While professing to control and punish 'errant' businessmen who ran their businesses to the ground, what this Act did was to extract concessions from everyone including bankers, creditors and even employees in order to 'nurse' the business back to health and hand it over to the very people who ran it to the ground.

It was all done in the name of labour.

Could you think of a greater fraud on the public than this Act? Mercifully, the Act has been repealed in 2016.

The stinger in the tail is that many of the businesses so 'revived' went on to borrow more and are in their death beds now.

There can be no better example of nefarious designs masquerading as noble intent turning into deadly outcomes.

A little-commented development which in my view led to the loans problem is the change in the structure of our banking system, which quietly happened starting the 1990s.

Prior to the 1990s the banks mainly provided working capital and 'term lenders' provided loans for long term requirements like plants, machinery, projects, and infrastructure.

These institutions (ICICI, IDBI and IFCI) were considered competent at what they were doing, with the quality of their assets inversely proportional to the government's holding.

Then ICICI merged with the commercial bank it had floated, followed by IDBI.

With the specialised institutions gone, every commercial bank jumped into the fray, financing long term despite being ill prepared for this task.

Flush with funds, lending became a cash management exercise.

Road projects, power generation plants, airports etc were financed left and right with apparently no regard for the projects' ability to repay.

This is largely held to be the most proximate cause of the banks' ills.

A related issue is the technical skills of PSU bankers.

A story from my past: 20 years ago a French colleague and I went calling on a number of PSU bank CMDs in Mumbai.

After the initial round of the various banks in Nariman Point area he started classifying them in order of their perceived calibre.

Then I took him to see Big Daddy, also in Nariman Point.

When we came out, he was visibly upset and said we had wasted our time meeting clerks in suits and should only have met Big Daddy.

The skill levels in understanding the banking environment, developments, problems, and prospects were totally lacking, in his opinion, in all except Big Daddy.

The old skill at 'managing up' is clearly insufficient to deal with today's issues and problems.

The results are plain to see for all who can read the headlines today.

And then there is the regulator.

They are a breed apart. They cannot tell you how to live, but find fault with you for dying.

In my experience their inspections are a litany of procedures not followed. But we know that once-best loan proposals are the ones on the death row now.

Perhaps it is time to get some outside help to analyse how things came to such a pass from the files of the failed loans.

I have reserved the piece de resistance to the very end.

One of the biggest reasons for business failure is that it happens! My late lamented father-in-law used to say that the largest cause of death is living.

We in India appear to assume, especially those in the government and regulatory circles, that if proper procedures are followed and required entries are made in designated registers, businesses can remain forever young like Markandeya.

Businesses fail despite the best laid plans.

Managements fail, markets change, products become obsolete, new competition emerges from unexpected sources, etc. We must accept it.

S Muralidharan retired as managing director, BNP Paribas, after serving the bank for 20 years.