A Financial Pandemic In The Making

Among the salient reasons cited for India’s fast-declining GDP growth in 2019 is a tightening of credit by banks and NBFCs. The latter in turn have been forced to take this step on account of growing non-performing assets (NPAs).

The central bank’s latest Financial Stability Report (FSR), released in December 2019 said that gross NPA ratio is likely to rise to 9.9% by September 2020 1 . This ratio stood at 2.5% in 2010 2 and the four-fold increase over a ten-year period is significant. Many analysts had expressed concerns that the deepening economic slowdown would have made it difficult for business and individuals to repay their loans even before Covid-19 arrived at our doorstep. The pandemic has of course solidified these apprehensions and now we are staring at a full-blown financial pandemic.

In March, RBI allowed banks to offer a three-month moratorium on loan repayments. A large number of companies have opted for the moratorium, despite being well aware that the delay in repayments will accrue additional interest and raise their cost of borrowing.

Against this background, the central government’s push to boost the credit flow for MSMEs through a government guarantee, announced recently as part of the financial package poses new challenges for the country’s financial sector. There is no doubting the intentions behind this move; as it is well accepted that improving the credit flow and availability to these businesses that contribute over 30% of India’s GDP, yet have rather limited financial access, is necessary to kickstart India’s economic engine.

As of 23rd June, INR 35,000 crore of the sanctioned INR 79,000 crore has already been disbursed under the Rs 3-lakh crore Emergency Credit Line Guarantee Scheme (ECLGS) for the MSME sector. According to Mint’s reporting, over 19,000 MSMEs have been reaping benefits of the scheme through both public and private banks.

The problem, however, lies in the present economic environment, reeling as it is already from a prolonged lockdown and a near-complete shutdown of all economic activity. The twin factors; the economic slowdown of pre-Covid 19 era and the nationwide shutdown; have combined to create an unprecedented situation of financial instability for the Indian economy and in specific for most MSMEs. The overall contribution of MSMEs to the total manufacturing output had declined from 42.2% in 2006-07 to 33.4% in 2017-18, potentially caused by the double shocks of demonetisation and GST roll out. As per Bloomberg’s reporting, the world’s biggest lockdown has attributed to an upward of 55% contraction in the country’s industrial output. It is the lowest production rate India has ever witnessed in the last two decades.

Despite the banks’ stated enthusiasm 3 to boost credit availability through top-up loans, the risks are evident. As of January 2020, TransUnion CIBIL and SIDBI reported that the bad loan ratio of MSMEs had reached its highest rate at 12.5%. Additionally, a majority of MSMEs are unsure of market demand returning soon, and they will naturally be hesitant to add to their existing debts in such times of economic certainty, a trend that emerged in the delay from sanction to disbursal of Government backed MSME loans.

We foresee a significantly large number of well-meaning and well-funded entrepreneurs running sustainable businesses succumbing to repayment defaults, on account of contraction in economic activity. Given this view, how prudent is it for banks to encumber the MSMEs with more loans, which will anyway increase their likelihood of a default? Irrespective of whether more credit is made available or not, we believe that Indian banks are quite likely staring at their gravest crisis to unfold over the next 12-18 months due to a sharp spike in NPAs. This risk of unprecedented level of loan defaults needs urgent planning and action by the lenders and the policymakers.

In our view, businesses that are availing moratoriums must be seen as a red flag and watched closely by banks and other lenders. The reasoning is simple: a business that is confident of its future cash flows will always seek to avoid the extra interest costs borne out of a moratorium. Banks and lenders therefore must undertake an immediate due diligence of all businesses who have shown interest in availing moratorium or have proceeded to avail it.

They say never waste a crisis. The economic environment such as the one we are experiencing at present can act like an ideal opportunity for fraudsters. It is imperative for banks to increase vigil and close monitoring towards ensuring that Disasterpreneurs do not take undue advantage of these moratoriums and easy credit and divert their funds.

The imminent economic slowdown and the resulting defaults will test the limits of the existing checks and balances in place to manage the accumulation of new NPAs and in turn test the resilience of our financial sector. Over the last decade, Indian banking sector has significantly evolved in its stressed assets management and resolution procedures and practices. It is imperative to acknowledge that the human race has not encountered an economic disruption of this magnitude ever before, just like it has not encountered the Covid-19 before. Situation demands that we adopt an agile and dynamic posture towards this crisis that have befallen us, both health and economic pandemic. Just like health pandemic, financial pandemic demands a reboot of our definition of Risk and our Risk Mitigation measures. Pre-emptive and pro-active approach needs to be adopted.

Whilst the Government and its policy makers devise the least painful way forward, it is imperative for the banks to review their risk mitigation posture and develop a pro-active approach by undertaking pre-disbursal reputation checks, lifestyle audits on the promoters and also to embark on a pre-emptive asset tracing of their unencumbered assets. A more robust and structured forensic audit mechanism must be incorporated and made a part of the sanction terms.

Several public sector banks have witnessed a lot of undeserved notoriety in the recent years on account of big-ticket frauds. They will do well to prepare well for what is about to hit them in the next few months. Just because we were not ready should not be the reaction that should be under par. After all a nation of 1.3 billion has taken upon itself to fight the health pandemic, it's now for the policy makers to do the same and ensure that we stop it from becoming a financial pandemic.