Indian Economy: Journey From 2016 to 2019

If blood is money for the Indian economy, the public sector banks make and distribute this blood throughout the system. We are going to discuss and see how we could have used what was happening in the public sector banks to make loads of money, on the short side. In one of the presentations by the RBI, the main points of concern were, the banks were weak on governance, had poor credit appraisal systems and were weak on risk management policies.

Most of the large projects were financed with very little equity from the promoters. THIS SMALL POINT IS EXTREMELY IMPORTANT and the RBI knew this. Power as a sector has weak fuel supply agreements and weaker power purchase agreements to pass through cost escalations. There was a complex web of corporate entities, with very high leverage; the corporates may be undertaking speculative borrowing or running Ponzi schemes by rolling over loans from the banks.

All this is extremely serious stuff and may not bode or reflect too well for previous RBI auditors, their teams or the governors. We do not want to pass judgment on anyone. The objective of this article is to understand the scenario, and then see whether we can ride up the spiral or ride it down. In a speech to the confederation of Indian Industry in February 2016, Dr. Raghuram Rajan indicated what he may have he may have had in mind when the AQR exercise was undertaken.

Existing loans may have to be written down some what. The promoter brings in more equity, other stakeholders, like governments- central governments and state governments, tax authorities, etc chip in, and the project is given a strong chance of revival, and the whole exercise incentivizes the promoter to bring the project back on track.

The three key factors to remember are -one, there was very high leverage in the projects and the loans given by the banks with very little equity participation from the promoter, the loans to be written down somewhat, the promoter to bring in more equity and other stakeholders to chip in so that the projects have a strong chance of revival.

These are the key points and driving factors for which the AQR exercise was undertaken. Well in September 2016, the baton of the RBI governorship passed to Dr. Urijit Patel, who was there till September 2018. Around late 2015 to mid of 2016, it became quite clear that the public sector banks were saddled with assets that could not service the interest, let alone the principal.

So in its capacity as a doctor the Reserve Bank of India gave the bank’s a PCA pill. The prompt connection action pill – what it meant was this, the banks were not allowed to do any material incremental business until they recovered the principal and the interest from the borrowers, and they were still getting completely and fully paid with all the perks.

Under this framework from an operational perspective, there were restrictions in the bank for getting into new lines of business, for adding branches for credit and non-credit allocation; there were reductions in non fund based limits and reductions in risky assets. So the bank was to do minimal work as a bank, with the employees still getting all the perks and getting fully paid.

That assumed to a large extent that the public sector banks had not really tried enough to recover the money. It assumed that the business was bad simply because the promoter was bad, was diverting money, did not know how to conduct his business, basically all the bad stuff. But what if, certain other stakeholders, like central and state governments, central and state-owned enterprises- had not kept up their end of the bargain – as a result of which, the very foundation basis which the project was financed had become defunct.

The smart promoters knew just how responsible this other stakeholder were and put in very little equity, the rest was all public money. By the end of 2017, 11 of the 21 listed public sector banks had been prescribed the PCA pill.

On 5th May 2016, another landmark law was passed – the insolvency and bankruptcy code 2016, better known as the Insolvency & Bankruptcy Code (IBC) 2016.

Impact of Insolvency and Bankruptcy code on Indian Economy

It had two main stages, stage 1 was the resolution process. In stage 1 a resolution professional was appointed. He would look into various facets of the business and decide whether the business was viable and could be salvaged or not.

Stage 2 came into force if stage 1 failed. In this stage, the creditors could take a call to sell the business and its asset to third parties. In most cases, stage 1 should have been a repetition. After all its the bank’s job to know how a business and its industry are doing.

stage 2 was a boon for the promoters and the banks. It took the monkey off both their backs. Now, imagine yourself in the shoes of the banker, if stage 1 of IBC 2016 is a success he would have to navigate through the entire process of lending, appraisal, monitoring again, with the same promoters, with the same management.

If stage 1 failed, there was a little personal downside anyway, You still had the job, you still had the perks, maybe some promotions would be delayed and some love lost but that’s about it.

Now imagine yourself in the shoes of the promoter- I put in very little equity anyways. I’ve drawn salaries, perks or offloaded stock at a higher price- why the hell should I work towards repaying these loans, when I have already recovered my money.

If you’re still in doubt which way the force in the spiral was, the RBI circular in February 2018 provided the massive jackpot queue . With one large swing of the sword, the Reserve Bank of India did away with all the existing mechanisms that the bank was running to put large and potent projects on track.

Basically what the circular said was if a resolution was not found within a hundred and eighty days of a reference date, usually 90 days from the first date of default, the project would be referred for liquidation.

Now if the business environment had turned hostile, and the larger ecosystem had failed to keep up- the project, the bank and the promoter had 270 days to put themselves in order. Well maybe the processes involved were flawed and slow, but the maybe the major flaws were not with the process, may be the major flaws were with the stakeholders involved well the process changed but the same people remained, the buyers of the business now knew the compulsions of the bank, the promoter- that they had a limited time frame in hand.

The bankers on the other side still kept their job, whatever happened. Not to be left behind SEBI introduced enhanced eligibility criteria, for stocks to remain in the futures and options segments of the exchanges.

The three major points were-the the stock should be in the top 500 as per market capitalization and average daily traded volume. The market-wide position limit should not be less than 500 crores and the average daily delivery volume should not be less than 10 crores for the previous six rolling months.

Now what that meant was that if an investor had leveraged himself via the futures markets, to buy a stock at a higher price, that stock would most probably be removed from the futures segment, if the price crashed a lot.

By linking the price indirectly to the market cap and the average daily delivery volume, the exchanges via the SEBI regulation actually accentuated the fall simply because, if the stock prices crashed the investor could not leverage the futures market to buy again we’re not here to pass judgment on the wisdom of the RBI, SEBI or the ministries.

They are what they are and they will continue to do, what they continue to do. We are here to understand the environment and pin point or try to pin point those variables which would be most sensitive to the environment and regulatory mechanisms which were changing. So as to identify those stocks which would either climb up the ladder or go down the spiral.

Also Read: Govt Reforms & Incentives for MSME Sector

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IndiaTaxLaws Team is an online knowledge bank for professionals like CA, CS, CMA, Advocates, MBAs, and Finance Professionals. We provide the latest updates, articles, notifications, circulars, court judgments etc. relating to taxation and corporate laws in India.

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