COVID-19 AND ITS IMPACT ON RETAIL AND SME LENDERS IN INDIA

There has been no prior experience as to the financial impact of a pandemic like COVID 19 on world financial markets. The nearest experience of such widespread disruption was the Second World War which was over many years and where large parts of humanity were left physically untouched by the event. Of course, there have been many smaller economic disruptions due to unforeseen events which provide some markers as to what to expect.

There were issues even before COVID-19:

Indian Banks and Non-Banking Finance Companies (NBFCs) have been grappling with a deluge of Non-Performing Assets (NPA’s) for the past three years. This resulted from a diverse set of reasons, the most prominent being poor credit decision making by public sector banks and NBFCs which were also prone to systematic fraud. Some private financial institutions like Yes Bank, DHFL and IL&FS are facing bankruptcy as their credit-bets started unravelling. Efforts by the regulator to manage this have been partially successful, however, the scale and scope of NPA’s have made all these efforts look insufficient. India’s financial managers were still struggling with these issues when the pandemic struck.

COVID-19 has added more dangerous elements to an already strained fabric of lending:

Before the pandemic struck, there was a distinct move towards retail assets by all the financial institutions as these had demonstrated better credit performance compared to SME and Corporate Assets. COVID has disturbed this oasis of stability as unemployment has spiked to unthinkable level in days and a large part of the workforce is unsure as to when they will return to work.

Key players in the Indian financial services landscape are Private and Public Sector Banks; Non-Banking Financial Companies (NBFC); Housing Finance Companies (HFC) and Micro Finance Institutions (MFI). Each of these institutions has defined its customer and product focus building significant expertise in their lending niche. We take a forward look at what these institutions will need to deal with in the immediate future and what will be the implications of the pandemic on credit behaviour:

  • MFIs to Face Losses in Urban Portfolios:

    Credit performance of MFIs has been exceptional due to two key lending practices; loans are linked to the individual’s earnings and are repaid on a daily or weekly basis. In addition, a larger group within which the individual resides guarantees the payment of the individual.

    During and post-COVID, the urban worker is going to be hit the worst. These are individuals running micro-businesses without any safety net. With the lockdown, it is likely that they will denude their working capital as well as the small assets that they have acquired for their business making it difficult for them to restart their business.

MFIs will have to make the difficult decision of supporting these individuals with additional loans to restart their business and regain the capability to repay their loans.

MFIs rural customers are in better shape as their economy has recommenced and the crop has been harvested infusing cash. I anticipate that MFIs will not have significant losses from this customer segment.

Standalone MFIs as well as banks and NBFCs who have acquired smaller MFIs to diversify their lending are going to take some losses in their urban portfolios. One key problem here is going to be that a lot of the urban poor have moved back to their villages. Some mitigation can be possible if customers with good credit records are provided additional credit or top-up to restart their micro-businesses once normalcy returns. This segment will see significant credit losses.

  • Losses Anticipated for NBFCs (and Banks) Who Focused on Higher Risk Portfolios

Unsecured lending is done both by NBFCs and Banks. Banks have focused on individuals with credit history while NBFCs have done subprime lending which reflects their cost of funds. This segment has been performing well for the past few years as it is priced to risk.

Salaried employees working for the government and large corporates will not have any salary erosion and their credit behaviour should mirror their past track. Those working for smaller SMEs which is the majority in the private sector will be impacted by the pandemic which will result in job loss or at best lower and delayed salary payment. Their ability to repay the loans will be impaired and will result in higher losses in this portfolio.

We anticipate significant losses for NBFCs who are focused on the higher risk portfolios. The banks with unsecured loan exposure will get away with higher losses but it is likely that many of their customers will be able to meet their loan commitments albeit with some delay.

Higher loan losses will be inevitable. Mitigation here is the price to risk.

  • The Impact on Secured Lending

Retail secured lending comprises two-wheelers, automobiles, commercial vehicles and housing loans.

Two-Wheelers:

These portfolios will perform better than the unsecured portfolios but will still see losses along with the job losses in the economy. Rural demand will continue to be robust and loan performance will also be good. Given the focus on individual transportation, there will be a strong second-hand marketplace which will enable the lenders to get a fair value for the assets they repossess. We anticipate a period of heightened losses in urban areas as customers earning capacity decreases. The eventual losses will be mitigated over a 12-18 month period as the repossessed assets are sold and recoveries have been made.

Automobiles:

The loans are both from salaried individuals as well as self-employed. The least impacted segment will be the salaried segment, that is the high-end white-collar worker, government employees and those employed with reputable private companies. Those individuals who are rendered unemployed will likely turn in their cars and go back to two-wheelers. Losses will be moderated by sale of repossessed assets.

The segment that will be most impacted will be those who are self-employed. Their performance will largely depend on the recovery and return to normalcy. If disruption to their earnings is more than 4 -6 months then the impact will be considerable. If recovery is sharp then many of them will bounce back and be able to pay their outstanding loans. This is a hardy segment with some financial assets and should do better than anticipated. Once again some short term additional write-offs followed by a couple of years of increase in recoveries.

Management of foreclosures, restructuring of loans and efficient sale of repossessed assets by the financial institution will determine the final losses in this category of loans.

Commercial Vehicles:

These portfolios consisting of CVs which are earning assets and pay for themselves have already been hit by the current lockdown and restriction in movement.

The health of these portfolios is going to be dependent completely on the rapidity of recovery and goods movement back to normal. We anticipate that this will take another 3-4 months which means that most borrowers will not be able to pay their dues for about six months. The logical way to deal with this is to restructure the loans. Larger transporters will be able to secure this with their lender.

The most hit by this slowdown will be the single truck owner who is likely to be forced to sell his vehicle. CV portfolios will see significant losses in the next 12 month period.

A new policy to scrap older CVs (Clunker Policy) could come to the rescue if announced and executed quickly.

 

Housing Finance:

As the bulk of these loans are for housing which provides accommodation for the borrower the anticipated loan losses here will be the least of any segment. Despite the proclivity to pay there will be some customers who will be unable to pay the monthly dues due to livelihood loss caused by COVID. The pain in this segment will be drawn over a period of time as there will be some payment waivers and the lenders will be inclined to show leniency in payment delays. Once the COVID pandemic is over and people are able to recover their livelihood then the longer-term impact will not be too significant.

In a scenario of the continuing impact of COVID on the economy, there will be considerable foreclosures resulting in a decline in the property market and eventual losses for the financial institutions.

Overall, this segment will perform the best and losses recognised may be high to begin with but the recoveries will follow as the assets will be sold over a period of time

  • SMEs the Worst Hit and the Consequent Impact on Financial Institutions
    The smaller and mid-sized SME companies are impacted the most by the disruption in the supply chain. They will need to pay their employees, purchase raw material, resume production and wait for their receivables to be paid before normalcy is restored. Their credit requirements are largely met by Loans against Property.

    It is my estimation that this set of borrowers will be the worst hit and a large number will not be able to get back into a stable business cycle given the huge increase in the degree of difficulty caused by COVID. As these loans are largely secured by property and the process for foreclosure is fairly routine under the safesi act, Indian lenders will see a huge amount of property being foreclosed. The key problem here will be the sale of this property due to insufficient demand. This will tend to drag the process longer than necessary with the attendant risk to the lenders

    Losses to Financial Institutions will not be immediate but it will take two or three years for the entire cycle to be completed. The loss to the economy, on the other hand, will be significant as many of these SMEs have developed a niche skill in production.

 

 

In conclusion, Retail and SME lenders can anticipate 2-3X write off compared to the prior year in most categories. If they segment their portfolio holdings on a risk basis they can separate the customers based on the continuity of income. By doing this the lenders will be able to focus on the riskier portfolio segments. Remedial action will need to be pro-actively taken and many loans will need to be rapidly restructured. For those not responding, collection activity will need to be efficiently carried out, the asset valued and sold at the earliest. The quantum of losses incurred by the financial institution will largely depend on their underwriting standards and the quality of execution in their ability to restructure, collect, foreclose and sell the assets. The game for these institutions has suddenly changed but will present new challenges and opportunities.

COVID like the disease itself leaves an ever-expanding footprint. In short, the financial impact on our institutions will need to be managed on a war footing. Let’s ready ourselves.

What’s Next for PSU Banks?

The newspapers and news channels have gone to town about the Punjab National Bank fraud with a potential loss of over 12k crores and counting; these are large numbers by any standard. The debate has veered towards taking political sides and somehow blaming the Reserve Bank of India, the Congress and or the NDA depending who is writing or talking on the news.

Unfortunately the debate has not focused on the real issues. To me there are only two:

First, why are PSU Banks more prone to frauds and unpleasant financial surprises?
And second, will a change in ownership of these Banks or privatization resolve this issue once and for all?

Historically two events have shaped the Banking Industry in India.
The nationalization of Banks in India in 1969 which led to the evolution of the Public Sector Banking, and the 1991 liberalization leading to the opening of Private Banks in India.

PSU Banks currently provide approximately 70% of the credit in the country, while the private banks
provide the rest.
Meanwhile, Private Banks in three decades have attained size, built strong technology infrastructure, have established a workable credit culture, have built capable and durable management bench strength, and have made and learnt from their mistakes in delivering
credit.

Their CASA ratios are good and their ability to manage their NPA’s have been well demonstrated. The Private Banks that did not do this well have closed down or have merged with the stronger private banks. Altogether a logical growth story.

The PSU Banks have not had a smooth ride and can be classified in two broad categories: the three large Banks who have been able to demonstrate a slightly better credit culture, have raised funding to meet their capital adequacy requirements, and have been profitable.

They now are grappling with high NPAs and have the management to work their way through the current crisis. The large PNB fraud has brought to the fore some of their management inadequacies and we can only wait to see their response to the current crisis which will provide a good indication as to their capacity to self correct and survive.

Their largest shareholder, the Government of India will need to demonstrate continued support in terms of equity infusion for these Banks to stabilize.

The remaining PSU Banks face an existential threat. They have extremely high NPA’s resulting from a compromised management, inadequate credit analysis capability, poor operational controls and a management which has got compromised over the years influenced by external pressures. With this as as their heritage survival in the present state is going to be difficult.

Finding a Workable Solution
Given the relatively bleak scenario in terms of credit delivery, how do we ensure that Indian industry gets the credit that it needs to grow?
● We must get over our fixation of PSU Banks and let them either be privatized or allow them to die in an orderly manner. They are unlikely to be the change agents who will provide credit to propel our industry. Two or three of the largest PSU Banks may be able to attract capital and grow. For these handful of Banks, we should have a clear disinvestment plan which enables this effort.

For the remaining PSU Banks we must prohibit them from lending, focus them on cleaning up their NPA’s and encourage them to sell whatever assets they can. These Banks will have to be nudged to closure over a period of time during which their only reason of existence will be to clean up the mess that they have created.

Large Private Banks will automatically step into the space and expand their lending. They are well-positioned to do so. The large market opportunity presented as the PSU Banks retreat and Private Banks take over the credit delivery role will be large and it is reasonable to expect that even the well-run mid-sized Banks will be able to attract the capital required to aggressively grow.

Large NBFC’s also will step in to provide credit to the customers that are not obtaining credit from Banks. The ecosystem of NBFC’s is well-established and has survived the numerous business cycles and will scale up very rapidly.

Large Corporates with good credit history have gone out to the capital markets frequently for their long term and working capital requirements. I see this trend becoming more significant.

Digital NBFC’s, Banks and Payment Banks will also change the landscape and provide more niche services as they attain size.

Going ahead the financial framework also has to ensure that there is one effective regulator for the Banks. Logically, the Reserve Bank of India (RBI) is this regulator. Currently, ambiguity exists as the PSU Banks also have dual reporting to the Ministry of Finance.

If we are to have effective governance of the banking industry, it is essential that
the entire regulatory responsibility for Banking be vested with the RBI without any interference of the Government.

In Summary

It is time for India to let go of its public sector banks.
The larger public sector banks should be privatized and sold at the earliest to obtain a decent market valuation. Funds received here should be utilized to capitalize the other public sector banks to ensure that they are able to absorb all the losses that they have to incur as the NPA’s go through the resolution process and have to be written off.

The other public sector banks should be restricted from lending, their healthy customers given a chance to find alternative borrowing arrangements and over a period of time closed as operating lending entities.

The private sector banks, NBFC’s and other Fintech start-ups will be happy to take on the onus of meeting the credit requirements of the country. We will also have a healthier financial services sector which will partner industry to provide the growth impetus required.

About the Author
Tushar Kanti Chopra is the founder Chairman of ATS Services Private Ltd, and has
been a banker with Citibank and Bank of America for over two decades.

India’s Banking Problem – A Viewpoint

I believe that the NPA story has been well documented and debated.

We all know how ex-Reserve Bank of India Governor Rajan, proactively recognised bad debts in banks and other financial institutions. Under his leadership, for the first time, there was a formal recognition of bad loans.  Quickly followed up with the legislation of The Bankruptcy Act, the government showed its commitment to put in place financial infrastructure to deal with this deluge of bad debts.  

The logical next step is to sell or restructure these distressed assets through NCLT.  Wouldn’t you think this would take place seamlessly?   Normally speaking, yes. In an ideal world, banks would write off the loan losses and fresh lending would re-commence once the bad loans are purged from the system.

Let’s stop for a second here: Will this happen in India?

To understand the delay in implementation, we need to know the players, the pressures, and the politics.  In India, these translate to the Public sector banks, the Private sector banks, and Government pressure.

While the Public Sector Banks provide about 70% of the loans in the Indian financial market they also contribute the largest amount of Non- Performing Assets. Their current capital and reserves are grossly inadequate to absorb the losses that are in their bad-loans portfolios.

Public Sector Banks’ genesis reveals a heritage that began with the nationalization of Imperial Bank in 1955 which transformed to become the State Bank of India. The next phase came in 1969 when Indira Gandhi nationalized 14 private Banks, followed by another 6 in 1980. Today, these Public Sector Banks are the repository of the bulk of the distressed assets within the banking sector.

The rot had set in decades ago. Although the State Bank of India inherited a skilled and dedicated management cadre, it was unable to resist political pressure when it came to taking a decision whom to lend to and under which terms. Many will recall, State Bank of India’s Managing Director R K Talwar resigning under pressure from Sanjay Gandhi.  The pressures exerted by politicians and businessmen has dominated the credit -decisioning in most PSU banks.

And the other player…

Manmohan Singh as the finance minister licensed a number of private banks. These banks have grown like weeds and constitute a mix of Corporate and Retail Lending with a robust deposit base. Without government support, they are conscious that they have to fend for themselves to deal with distressed assets. This has made them more agile and vigilant than their PSU peers.  

They require little support to rapidly grow in size and scope. The key to their success has been their independent credit and underwriting capability, adoption of technology and their ability to market their products to retail customers. The challenge for them is to grow to a size where they are equal to their international competitors.

Unlocking the potential of PSUs: Divide and Conquer

The key to the current NPA problem has been:

  • Weak underwriting standards,
  • Lack of independent credit decision making, and
  • Opaque management actions.

Unless this is resolved in a radical manner, new lending will continue to result in ballooning bad credits.

 

To achieve a sustainable transformation, consider identifying two or three large PSU Banks and strengthen their credit underwriting capabilities. There is abundant talent available in India to provide the leadership.


Eliminate undue political pressure
and make the management remuneration in line with private banks. This will encourage the Banks to lend in an ethical and rule-based manner while attracting top class talent.

Adoption of Technology is already underway in PSU Banks and can be used to build the necessary transparency required to manage credit growth reflecting international parameters. The recapitalization Bonds to be issued should also go to these Banks.

The remaining PSU Banks should transfer their healthy assets to the above large PSU Banks. They should not be permitted to lend but must focus only on the resolution of their Bad Loans. As they work through this we will find that their balance sheets will start shrinking. It is likely that their deposits will also move to other Banks. The possibility of merging all these unviable PSU Banks into one Bad Bank also exists.


The tough decisions to be also considered are: closure of their Branches, dealing with the redundant staff via Voluntary Retirement Schemes and sale of all their assets including any unhealthy assets which can be sold off.  There will be some capital required to make up the difference between the actual losses and the remaining capital of the Bad Bank. At least a framework emerges which will result in solving this problem over a three to five year period.

What about Non-Banking Finance Companies?

These have been long ignored both by regulators as well as the capital markets.  Most NBFCs do not take deposits which makes their funding cost higher than Banks. This forces them to seek riskier loans which enable them to get higher returns.  This structural design has resulted in numerous large NBFCs getting into credit problems and facing closure.  Interestingly, NBFCs actually play a critical role in delivering credit to the less creditworthy. 
With demand from first-time borrowers – both SMEs and individuals – increasingly NBFCs will have the market to grow rapidly.

They are largely privately owned, many listed on the stock market and the better run entities outstrip the Private Banks in terms of growth. The key risk they need to manage is their cost structure and the quality of credit delivered.

This segment is pivotal in providing credit where Banks fear to tread.

Fintech companies a variant to the NBFC story

By integrating customer information online and using surrogates to monitor the flow of sales Fintech companies are nimble and quick in terms of their capability to lend to SME’s and Individuals, currently unable to formally borrow. The Fintech companies could tie up with large Banks and NBFCs could become a force multiplier for the economy.

Quo Vadis

PSU Banks are the largest component of the Banking mosaic today. They are unhealthy and have to undergo a detox that revives their well-being through deep cleansing, nips and tucks, splicing and dicing. The methodology to repair their capital structures via recapitalization bonds has been enunciated but will need a drastic facelift of the credit delivery system and elimination of errant entities.

And the Award goes to…

The Private Banks and NBFCs who are willing and ready to step to meet the credit requirements of the economy.

About the Author

Tushar Kanti Chopra

Tushar is the founder Chairman of ATS Services Private Ltd, and has been a banker for over two decades.