CA Parth B. Talsania
What is the best investment choice for the ordinary investor?
There is palpable disappointment when the answer is: there is no such choice. Everything is risky from taking the road to choosing a partner. Risk, return and diversification are fundamental ideas that each investor has to learn, without protesting about entitlements. There is nothing like risk-free asset. But the good news is that financial structures can be created to come close to that ideal. Consider the much coveted bank deposit. Many of us trust the bank; there is little reason why we should not. The structure of a bank has been honed over years to protect depositors. This despite the fact that the bank uses the depositors’ money to make risky loans.
“Indian Banks need to be capitalized!”
A bank cannot simply take deposits and make loans. It has to back its promise to its depositors with a solid balance sheet structure. There are four primary ingredients that make a bank deposit nice and robust investment product.
First, a bank cannot fund all its loans with deposits. It has to have its own capital. For example, if a bank wants to have a loan book of Rs.100, it can raise Rs.90 as deposits but, to do so, it must first raise Rs.10 as equity capital. The equity capital has to be adequate to cover the risks of the loans. What does this mean? If Rs.10 is equity capital and Rs.100 has been lent out, the bank has allowed for a risk of Rs.10 on its loans or even if 10% of its loans go bad, it can still repay Rs.90 to its depositors. When we speak of capital adequacy norms, we refer to the regulatory requirement, which weighs the loans based on each category’s risk, and asks the bank to first raise equity capital, to provide the cushion, so that depositors are protected. This is why, when banks’ nonperforming assets (NPAs) go up, we now talk of banks’ need to be ‘capitalised’.
Second, a part of the deposits is kept as cash with the central bank, to meet exigencies. Third, a part of assets have to be statutorily kept in safer government securities, only the rest can be lent as risky loan. Lastly, if a bank finds that its loans have gone bad, it has to provide for them from its profits. All these ingredients make the bank’s balance sheet a dependable structure for investors who deposit money, earn the stated interest, and access it when they like.
Hoping to earn a high return, in its quest to maximize profits, a bank may give very risky loans. The bank may be reckless in its lending practices, making loans to poor quality borrowers. The primary risk of all these events impacts the equity investor. In our example, if the loan book falls in value form Rs.100 to Rs.92, the deposit holder will still get back Rs.90. But the equity investors’ value has eroded from Rs.10 to Rs.2.If the bank hides its bad loans, or fails to provide, or does not get more equity capital to support the risky assets, it could default on its deposits too. This is why equity is riskier than debt. But not all promises made by a borrower to a lender are good. It all depends on the quality of the assets and the structure of the balance sheet. If one bank has low NPAs and good equity value, it is qualitatively better than another bank with high NPAs and low and falling equity values. Many who assume that nothing can go wrong with PSU banks are not guided by the principles of finance, but by the blind faith that the government will not allow the banks to fail.
When a bank is stressed by bad loans, it needs equity capital- to make new loans and to price and service its depositors competitively. A bank with a weak balance sheet will have to pay more for deposits. It has to make riskier loans to make profits. Therefore, a weak bank is not a great place to be in. If the government has to step in, it has to find money to be an equity investor in the weak bank, or fund other equity investors. Both tasks are tough.
What about other investments? In each case, the structure is what matters. In a company deposit, the asset of the company matters. If it is a profitable business, and if it is adequately capitalised, it might be a good investment option. In a PSU, or any other company bond, the same principle works. In any debt investment, investors should take the time to see what is at work to protect their money. As a rule, lending to a business whose equity share prices are failing is bad idea. The risk of the assets is what the equity prices reflect.
How about equity? An equity investor is directly exposed to the risk of the assets. The only protection to the equity investor is diversification. All assets don’t go bad at the same time. If an equity investor’s shares are spread across different businesses, the risk of failure will be lower. For example, an investor holding PSU bank stocks and private banking stocks, might be better off than one holding only PSU bank stocks.. An investor holding banking, pharma and IT stocks might fare even better. But the risk cannot be eliminated completely.
So, what does taking charge mean? Three key things. First, there is no guarantee in modern finance. A promise about return is as good as the balance sheet on the basis of which it is made. Second, diversification is the key to reducing risks arising from promises gone weak or bad. Third, there is no point trying to forecast the future. Even the best loans can fail, and great companies can fall. To invest means accepting that returns will always come with risks, and that diversification is more sensible than mindless speculation about the future.
What are non –performing assets?
As per RBI guidelines, NPA is defined as under:
Non -performing asset (NPA) is a loan or an advance where:
- interest and/ or installment of principal remain overdue for a period of more than 90 days in respect of a term loan,
- the account remains ‘out of order’ in respect of an Overdraft/Cash Credit (OD/CC),
- the bill remains overdue for a period of more than 90 days in the case of bills purchased and discounted
*Any amount due to the bank under any credit facility, if not paid by the due date fixed by the bank becomes overdue.
What does “out of order” mean?
An account should be treated as ‘out of order’ if the outstanding balance remains continuously in excess of the sanctioned limit / drawing power. In cases where the outstanding balance in the principal operating account is less than the sanctioned limit / drawing power, but there are no credits continuously for 90 days or credits are not enough to cover the interest debited during the same period, these accounts should be treated as ‘out of order’.
Inference: What does “no credits” mean? In case of businesses availing the facility of CC, which is generally against hypothecation of stock and debtors, assuming the outstanding balance is less than sanctioned limit or drawing power then if the company is not routing its sales through it CC bank account for continuously 90 days or that amount is not equivalent to interest debited by bank during the same period, then this account shall be treated as out of order
Let’s get deeper now:
What really happens if a loan goes bad?
As soon as an account is reported as NPA, lenders form a lenders’ committee to be called as Joint Lenders’ Forum (JLF) under a convener and formulate a joint corrective plan (CAP) for early resolution of stress in the account. The intention of this Framework is not to encourage a particular resolution option, e.g. restructuring or recovery, but to arrive at an early and feasible resolution to preserve the economic value of the underlying assets as well as the lenders’ loans. The options under Corrective Action Plan (CAP) by the JLF would generally include:
(a) Rectification – Obtaining a specific commitment from the borrower with identifiable cash flows within the required time to regularise the account so that the account does not slip into the NPA category, within a specific time period acceptable to the JLF without involving any loss or sacrifice on the part of the existing lenders. If the existing promoters are not in a position to bring in additional money or take any measures to regularise the account, the possibility of getting some other equity/strategic investors to the company may be explored by the JLF in consultation with the borrower. These measures are intended to turn-around the company without any change in terms and conditions of the loan. JLF may also consider providing need based additional finance to the borrower, if considered necessary, as part of the rectification process. However, it should be strictly ensured that additional financing is not provided with a view to evergreen* the account.
*There is an established practice in almost all co-operative banks to keep the loan account EVERGREEN. To Illustrate and to make it more clear : say a bank disburse a loan of Rs.10000 to a farmer and the account become overdue after a year or two , the same bank sanction a loan of Rs.20000 or Rs.30000 which enable farmer to repay first loan and avail only extra loan . In the same way bank use to sanction inflated loan year after year, this keeps the account always standard. During the course of time, public sector banks have also learnt the art of keeping the loan account evergreen. Under evergreening, banks provide additional loans to stressed borrowers, often indirectly, to enable them to repay existing loans that can keep a loan from going sour, but it ratchets up a bank’s exposure to a troubled credit and the odds, in most cases, are against it.
(b) Restructuring – Consider the possibility of restructuring the account if it is prima facie viable and the borrower is not a wilful defaulter, i.e., there is no diversion of funds or fraud etc. At this stage, commitment from promoters for extending their personal guarantees along with their net worth statement supported by copies of legal titles to assets may be obtained along with a declaration that they would not undertake any transaction that would alienate assets without the permission of the JLF. Any deviation from the commitment by the borrowers affecting the security/recoverability of the loans may be treated as a valid factor for initiating recovery process.
Let’s consider an example here:
Assume a company with the below stated financial parameters:
| 2012-13 | 2013-14 | 2014-15 | Total | |
| (Rs. in Cr.) | ||||
| Net Sales | 150 | 170 | 160 | 480 |
| EBITDA | 45 | 50 | 53 | 148 |
| Less: Normal CAPEX | -3.3 | -3.5 | -3.5 | -10.3 |
| Cash flow available for debt servicing | 41.7 | 46.5 | 49.5 | 137.7 |
| Debt servicing requirements | 117 | 125 | 118 | 360 |
| Repayment as per existing schedule | 62 | 80 | 84 | 226 |
| Interest | 55 | 45 | 34 | 134 |
| Cash Gap | -75.3 | -78.5 | -68.5 | -222.3 |
| Cumulative Cash Gap | -75.3 | -153.8 | -222.3 |
Since the existing debt schedule indicates peak cash flow gap of Rs. 222.30 crore, it is clearly unsustainable and so the company may decide to restructure their loans.
Next question is why a bank will agree for restructuring?
Restructuring typically entails extending tenure on the loan, easing interest rates or even converting debt to equity.
Consider a bank has sanctioned Rs 150 Crore Term Loan to a company.
RBI has directed the banks to make provisions or set aside money when the account turns bad.
| Sr. No | Classification | Provisioning Requirements | ||
| 1 | Standard | 0.40% | ||
| 2 | Sub-Standard Asset /NPA | Secured | 15% | |
| Unsecured | 25% | |||
| 3 | Doubtful Asset | |||
| ( Asset remains NPA for 12 months or more ) | ||||
| a | Upto 1 year | Secured | 25% | |
| Unsecured | 100% | |||
| b | 1 – 3 years | Secured | 40% | |
| Unsecured | 100% | |||
| c | More than 3 years | Secured | 100% | |
| Unsecured | 100% | |||
| 4 | Loss Asset | 100% | ||
Now, assume of Rs.150 crore, Rs.100 Crore term Loan is outstanding against security currently fetching market value of Rs. 80 Crore. Rs.20 Crore is unsecured portion for the bank. Now, if the loan account turns NPA/ slips to sub-standard category, bank has to provide in its books/ profit & loss account – Provision for bad or doubtful debt of Rs.12 Cr ( 15% on Rs.80 Crore ) & Rs. 5 Cr. (25% on Rs.20 Crore ).
If bank opts for restructuring, it will extend the tenure of the loan and will ease the interest rate on the loan. This will call for the bank to make provision in its books / provide for loss on account for diminution in fair value of the asset or loan.
Pre – Restructuring Cashflows
| Year | Principal Repayment | Outstanding Balance | Interest Payment | Total Cash Outflow |
| Rate Of Interest – 14% | ||||
| 100 | ||||
| 1 | 20 | 80 | 14.00 | 34.00 |
| 2 | 20 | 60 | 11.20 | 31.20 |
| 3 | 20 | 40 | 8.40 | 28.40 |
| 4 | 20 | 20 | 5.60 | 25.60 |
| 5 | 20 | 0 | 2.80 | 22.80 |
| Total Outflow | 142.00 | |||
| Original NPV | 95.69 |
Post- Restructuring Cashflows
| Year | Principal Repayment | Outstanding Balance | Interest Payment | Total Cash Outflow |
| Revised Rate of Interest -12% | ||||
| 100 | ||||
| 1 | 10 | 90 | 12 | 22 |
| 2 | 10 | 80 | 10.8 | 20.8 |
| 3 | 10 | 70 | 9.6 | 19.6 |
| 4 | 10 | 60 | 8.4 | 18.4 |
| 5 | 10 | 50 | 7.2 | 17.2 |
| 6 | 10 | 40 | 6 | 16 |
| 7 | 10 | 30 | 4.8 | 14.8 |
| 8 | 10 | 20 | 3.6 | 13.6 |
| 9 | 10 | 10 | 2.4 | 12.4 |
| 10 | 10 | 0 | 1.2 | 11.2 |
| Total Outflow | 166 | |||
| Revised NPV | 87.08 |
In the above cash flows, we entail revision in interest rate i.e. 14% to 12% and extension of loan tenor i.e. 5 year to 10 year. The erosion in the fair value of the advance should be computed as the difference between the fair value of the loan before and after restructuring. Fair value of the loan before restructuring will be computed as the present value of cash flows representing the interest at the existing rate charged on the advance before restructuring and the principal, discounted at a rate equal to the bank’s BPLR or base rate (whichever is applicable to the borrower) as on the date of restructuring plus the appropriate term premium and credit risk premium for the borrower category on the date of restructuring. Fair value of the loan after restructuring will be computed as the present value of cash flows representing the interest at the rate charged on the advance on restructuring and the principal, discounted at a rate equal to the bank’s BPLR or base rate (whichever is applicable to the borrower) as on the date of restructuring plus the appropriate term premium and credit risk premium for the borrower category on the date of restructuring.
As we see above, the difference in NPV of Rs. 8.60 Cr (95.69 – 87.08 ) is called the sacrifice done by the lender to restructure borrower’s loan and it is the amount bank needs to provide on account on diminution in fair value of the asset. RBI stipulates banks to also provide 5% of O/s amount i.e (100 * 5%) in their books for keeping the account under category “standard restructured asset”. Hence, the total provisioning shall be Rs.13.60 Cr (8.60+ 5) as against Rs.17 Cr if the bank had not restructured the loan.
Is it that all the companys’ under stress can get their debt restructured?
No. Below are the cases where banks will not agree to restructure borrowers’ debt
- Where there is diversion of funds which includes any one of the under noted occurrences:
(a) utilisation of short-term working capital funds for long-term purposes not in conformity with the terms of sanction;
(b) deploying borrowed funds for purposes / activities or creation of assets other than those for which the loan was sanctioned;
(c) transferring funds to the subsidiaries / Group companies or other corporates by whatever modalities;
(d) routing of funds through any bank other than the lender bank or members of consortium without prior permission of the lender;
(e) investment in other companies by way of acquiring equities / debt instruments without approval of lenders;
(f) shortfall in deployment of funds vis-à-vis the amounts disbursed / drawn and the difference not being accounted for.
- Where there is Siphoning of funds, which is construed to occur if any funds borrowed from banks / FIs are utilised for purposes un-related to the operations of the borrower, to the detriment of the financial health of the entity or of the lender. The decision as to whether a particular instance amounts to siphoning of funds would have to be a judgement of the lenders based on objective facts and circumstances of the case.
The identification of the wilful default should be made keeping in view the track record of the borrowers and should not be decided on the basis of isolated transactions/incidents. The default to be categorised as wilful must be intentional, deliberate and calculated.
(c) Recovery – Once the first two options at (a) and (b) above are seen as not feasible, due recovery process may be resorted to. The JLF may decide the best recovery process to be followed among the various legal and other recovery options available with a view to optimising the efforts and results.
Inference :The problem is that many such loans are never recovered ,adding to the challenge of collecting on bad loans in a country where there is no bankruptcy law – the absence of which makes banks more inclined to help borrowers rather than declare a loan to be in default and receive nothing.
End-use of Funds
In cases of project financing, the banks / FIs seek to ensure end use of funds by, inter alia, obtaining certification from the Chartered Accountants. The banks and FIs, should not depend entirely on the certificates issued by the Chartered Accountants but strengthen their internal controls and the credit risk management system to enhance the quality of their loan portfolio.
Some of the illustrative measures that could be taken by the lenders for monitoring and ensuring end-use of funds:
(a) Meaningful scrutiny of quarterly progress reports / operating statements / balance sheets of the borrowers;
(b) Regular inspection of borrowers’ assets charged to the lenders as security;
(c) Periodical scrutiny of borrowers’ books of accounts and the no-lien accounts maintained with other banks;
(d) Periodical visits to the assisted units;
(e) System of periodical stock audit, in case of working capital finance;
(f) Periodical comprehensive management audit of the ‘Credit’ function of the lenders, so as to identify the systemic-weaknesses in the credit-administration.
(It may be kept in mind that this list of measures is only illustrative and by no means exhaustive.)
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Dear Sir,
Thank you for such a meaningful article and Bank financing; this is probably one of the best articles I have ever found, better than many authoritative literature on the subject. I would request you to make a similar article on Project Financing and what are the parameters a borrower has to keep in mind, while approaching lender for funding. And what are the practical issues in getting project funding from banks and financial institutions. This would help a lot of beginners.
Thank you
CA Ravi Kiran R