Crony capitalism or clean-up of a messy legacy?

India went through this summer reading headlines like these:

“No farm loan waiver in sight, Karnataka farmers to hit the streets today”

“Public sector banks write-off bad loans worth Rs 1.2 lakh crore in 2017-18”

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“Rs 1.44 lakh crore: That’s the record bad loan write-off by banks in 2017-18

“NPA crisis: Public sector banks write off Rs 1.20 lakh crore in FY18, as against Rs 81,683 crore in FY17”

Reading the above headlines, a tax paying commoner like my aunt, who once asked me the same question, would have thought –

“And I am charged 30 per cent of my income as taxes to see it get flushed down the drains!?“There surely is going to be a recession like in 2008” 

Out of curiosity, he would go on to read the articles in detail to figure out where his taxes are actually going. And he would conclude – “To the pockets of these crony capitalists”.

This is the information that a commoner is fed and hence concludes – “First demonetization, then GST and now waive off of corporates’ loans. Like the economy was in great shape for them to have written off loans. Is this how the Government rewards an honest, middle class, tax paying citizen?”

But a ‘write off’ is different from a waive off’. And it’s time to understand the issue step by step.

What are Non-Performing Assets (NPA)?

Money lent by banks on which it earns interest over the period are considered assets of the banks. Depending upon the terms of the loan agreement, lenders are required to repay the principal along with interest on agreed upon due dates.

While NPAs, as they are rightly called, are loans which are not performing for the banks, or let us say, which are not contributing to the earnings of the bank.

Technically speaking, NPAs are the loans provided by the banks for which the lender fails to make payment either of the interest or the principal or both, for a period exceeding 90 days from the due date, subject to certain exceptions.

To put it in a simpler way if one borrows Rs 1,00,000 from a bank on January 1st, 2018 for which one agrees to pay a sum of Rs 1,000 as interest every month. If he does not pay the interest on January 31, February 28 and even on March 31 of that year, then the loan is considered to be an NPA by the bank.

Will the bank recognize the above interest as its income for the period January-March 2018?

Yes, the banks will still recognize the income of Rs 3,000 on an accrual basis in its books for the year ended March 31, 2018. Accrual basis is nothing but a method of recognizing an income when it is earned and not when it actually received.

Now, on April 1st, 2018, if one has failed to pay the interest on the loan for a period exceeding 90 days from the due date, the bank will recognize the loan assets as an NPA. As per the Reserve Bank of India (RBI) guidelines, it will also have to reverse the interest accrual of Rs 3,000 which was recognized in its books as interest income for the year ended March 31st, 2018. Further, the bank, in compliance with the Banking Regulations Act, 1949 and the relevant RBI guidelines, will start making provisions for the expected future losses of principal sums lent that may not be repaid.

Now, comes the real question, when and why do we ‘write off’ the NPAs?

For a loan to be written off, they should be considered as loss assets. Which, as per the RBI guidelines mean, loans considered as loss asset and identified as such by the RBI or the bank itself or by the auditors.

Banks first term the loan as an NPA, under which there are sub-categories like sub-standard assets, doubtful assets and then comes the dreaded loss assets category. This categorization of a loan ends when the banks write off. The time taken for a loan to travel through the various categories is greater than 3 years. Which basically means that the default occurred much before demonetization or GST or any other policies of the government.

On realizing this, one might think – “Oh, this shows that the present government lent all our taxes to the crony capitalists, who never payback”

Usually, the banks do not like to create provisions on their bad assets because it negatively impacts on their profitability for the year, denting their market capitalization and investor’s sentiments. The banks used to follow their own method of assets classification and provisions recognition, thereby depicting higher profits and higher loan assets.

RBI recognizing such divergence, issued its guidelines vide notification dated April 18, 2017, requiring all the banks to disclose in their financial statements any divergence in the asset classification and provisioning.

And this is where we introduce a concept of ‘evergreening’ of loans. This is a highly sophisticated technique that the banks have been using since time immemorial to show lesser NPAs, thereby increasing their book profits. You may wonder why the banks do that. Well, the banks are not charitable institutions.

To understand the modus operandi of ‘evergreening’ of loans, let’s say, the loan which turned into an NPA has now been paid back. But this was possible only due to a new loan that was provided with different payback period. So, basically, both the lenders and the banks used to be in a win-win situation wherein the lenders got more time to pay back the loan while the banks could show higher profits and higher loan assets than the actual scenario.

So why the sudden surge in the numbers of NPAs, and its subsequent write-offs?

Yes, it is true that the NPAs have recently increased to a mammoth level and the write-offs make you feel that the Indian economy is in shambles and it could only go down to the 2008 economic crisis. However, the reality is different. The RBI has taken some concrete action from time to time to curb such practices, one of such being RBI guidelines dated February 12, 2018, withdrawing the ‘evergreening’ of loans and this is when the banks were left with no option but to recognize the loss assets and subsequently write them off to clean their balance sheets.

This was when the skeletons fell off the closet of almost all the banks, especially the public sector banks like State Bank of India (SBI) and Punjab National Bank (PNB), which were used as political tool by the then government to grant loans to their favoured corporates.

It is pertinent to note that most of these loans that turned into loss assets were extended in the past decade without any due diligence or a proper mechanism to cater to the vested interest of the party in power. The NPAs were just ‘evergreened’ by the banks to show higher profits thereby increasing the variable pay of the executives and taking investors for a ride.

The eternal question to be asked here is why the current government did not disclose the mess that was left behind by the Congress government.

This question was answered in an interview of Prime Minister Narendra Modi. Following is the relevant extract of the interview:

Question: While there has been economic growth, private investment in the economy is still tepid. Some sectors like real estate are still in trouble. Venture capital funding of startups has slowed. What message would you like to give to private industry and foreign investors at this juncture?

PM Modi: Today I think, before presenting the first Budget, I should have placed a White Paper in Parliament on the economic situation in the country. This thought had struck me then. I had two paths then. Politics told me that I should put out all the details. But the nation’s interest told me that this information would increase the sense of hopelessness, markets would be badly hit, it would be a big blow to the economy and the world’s view of India would get worse. It would have been very difficult to get the economy out of that… I chose to stay silent in the national interest at the risk of political damage. At that time the situation in public sector banks was coming out… I didn’t put these details out in public. It hurt us, we were criticised, it was made to look like it was all my fault. But I took the political damage in the country’s interest. The impact of all these issues from the past has impacted private investment, like the non-performing assets in banks. I held a session with bankers and told them there will be no call from the government to you. These steps would have tightened the screws.”

However, only recently did the music stop and the silence deafened everyone including the common man. Suddenly, everyone started to speak of the risk India faced due to bad loans. But now, don’t we all agree that this is a result of bad lending practices? Possibly due to bad politics?

Once the NPA mess is understood threadbare, the difference between Write off and Loan waiver becomes essential. The terms are often interchangeably used by the so-called journalists in our esteemed media houses. In fact, the RBI, in an unprecedented move, had to intervene to clarify what’s being reported in our media.

The Oxford dictionary defines ‘write-off’ as “A cancellation from an account of a bad debt or worthless asset.” The same dictionary defined a ‘waive off’ as “Refrain from insisting on or using (a right or claim)”.

If you read the two definitions closely, a write-off signifies that it’s just a cancellation from an account, meaning reduction from an account. However, the term waive off leads to a proposition of relinquishment of a right or a claim of the loan.

To better understand, let us take an example:

You lend a Mount Blanc pen to your friend, Shyam, who wanted to impress his girlfriend, Priya. As days passed by, Shyam does not pick your calls and stops replying to your emails, nor is he traceable. In your mind, you assume the Mount Blanc pen to be gone forever and to find closure, you start accepting that you may never get it back. So in your mind, you WRITE-OFF the pen as your asset. However, please note that the moment you catch hold of Shyam, you will ensure you get your pen back.

Alternatively, imagine a situation where Shyam approaches you and informs you that his girlfriend really like the pen and she kept it for herself. You know that Shyam cannot afford a Mont Blanc pen and hence, out of affection for your friend, you tell him that he need not return the pen. You, then have WAIVED OFF the right to get the pen back.

The above example is exactly what the banks do in case of a ‘write-off’ and a ‘waive off’ respectively. Now a question may arise as to why the banks’ write-off. The answer lies in the complicated income tax provisions applicable to banks. Without getting into the details, banks get to reduce their tax liability when they write-off their bad loans. Also, it makes their balance sheet look cleaner with such loans not being a part of the NPAs anymore.

Relevant extract of the Income-tax Act, 1961 is reproduced hereunder:

Writing off of NPAs

8.1 In terms of Section 43(D) of the Income Tax Act 1961, income by way of interest in relation to such categories of bad and doubtful debts as may be prescribed having regard to the guidelines issued by the RBI in relation to such debts, shall be chargeable to tax in the previous year in which it is credited to the bank’s profit and loss account or received, whichever is earlier. 

8.2 This stipulation is not applicable to provisioning required to be made as indicated above. In other words, amounts set aside for making provision for NPAs as above are not eligible for tax deductions.

8.3 Therefore, the banks should either make full provision as per the guidelines or write­-off such advances and claim such tax benefits as are applicable, by evolving appropriate methodology in consultation with their auditors/tax consultants. Recoveries made in such accounts should be offered for tax purposes as per the rules.

A ‘write-off’ is merely a book adjustment. Whereas, a ‘waive off’ is a relinquishment of the right to receive the loans provided. This again results in a lower tax liability to the banks, however, the borrower pays tax on such waived off loan subject to certain conditions as the borrower need not repay the loan, which in essence is his income.

A ‘waiver’ is when political parties announce that farmers need not repay their loans. The Congress-led United Progressive Alliance (UPA) announced farm loan waivers in 2008 as part of its election manifesto, consequently, they were re-elected. Farm loans aggregating Rs 72,000 crore were waived off subsequently.

In a waive off, the government guarantees to pay the loans to the banks. One may debate on the rationale of the farm loan waiver, but it certainly disrupts the credit culture of the nation.

Sometimes, the banks have loans which are waived off, usually by the governments by calling it a bail-out package. So now, coming back to the original question – “I pay 30 per cent of my income as taxes for this!?

No. A write off does not mean that the banks are not going to recover the loans from the corporates. With Insolvency and Bankruptcy Code (IBC), 2016, which is also considered as one of the biggest economic reforms and asset securitization industry booming in India, it’s about time that we have more recoveries of the NPAs. One such example is the case of Bhushan Steel where the banks recovered almost the entire loan advanced of a whopping Rs 35,200 crores. Over 2,000 cases have already been closed under IBC, resulting in a massive recovery of NPAs crore, according to published reports.

Gone are those days when media, also termed as the ‘Fourth Pillar of the Nation’ enjoyed an undisputed power without accountability. Thanks to the emergence of social media, people now have access to information like never before with updates from across the world at their fingertips. It thus becomes necessary that media be responsible and provide credible information to its readers while reporting.

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