Stressed Assets Resolution Frameworks – tracing the evolution

There is a need to ensure that the banking system recognises financial distress early, takes prompt steps to resolve it, and ensures fair recovery for lenders and investors

TR SHASTRI

Prof. Shastri is a former Banker, Bangalore

WITH the slowdown of the economy, a number of companies/ projects are under stress. As a result, the Indian banking system has seen increase in NPAs and restructured accounts during the recent years. Stressed assets are a burden on the lenders and a drag on the economy. Therefore, there is a need to ensure that the banking system recognises financial distress early, takes prompt steps to resolve it, and ensures fair recovery for lenders and investors. Adding to these, RBI also had stated that ‘Improving the system’s ability to deal with corporate distress and financial institution distress by strengthening real and financial restructuring as well as debt recovery’ is one of the five pillars on which its developmental measures will be built for improving the financial system. These observations by RBI made several years ago are valid even now. Because, as per RBI’s Financial Stability Report of this year (2020), macro stress tests for credit risk indicate that the gross NPA ratio of all scheduled commercial banks may increase from 8.5 percent in March 2020 to 12.5 percent by March 2021 under the baseline scenario; the ratio may escalate to even 14.7 percent under a very severely stressed scenario.

Before a loan account turns into an NPA, banks are required to identify incipient stress in the account by creating a sub-asset category – Special Mention Accounts (SMA) – as per RBI guidelines since 2002. There are three subcategories thereunder – SMA 0, 1 & 2 – depending on the age of overdues, thus, showing increased levels of stress. RBI also opined that while proper credit risk management and credit discipline among lenders are needed, some regulatory and governmental measures may also be required to address the factors that are leading to deteriorating asset quality. There is a need to ensure that the banking system recognises financial distress early, takes prompt steps to resolve it, and ensures fair recovery for lenders and investors. Empirical evidence suggests that the profitability of banks which delay recognition and adequate provisioning for impaired assets is adversely affected as compared to those that act in a timely manner.

RBI had issued various instructions aimed at ‘resolution of stressed assets in the economy,’ including introduction of certain specific schemes at different points of time till June 2016 and a major consolidated circular in 2018. A brief list of these measures is given on page .... Such earlier instructions included Framework for Revitalising Distressed Assets, Corporate Debt Restructuring (CDR) Scheme, Flexible Structuring of Existing Long-Term Project Loans, Strategic Debt Restructuring Scheme (SDR), Change in Ownership outside SDR, and Scheme for Sustainable Structuring of Stressed Assets (S4A). RBI had introduced a Joint Lenders’ Forum (JLF) as an institutional mechanism for resolution of stressed account.

While these schemes did not yield the expected resolutions or improvements in NPA situations, there were too many of them, overlapping and confusing. Hence when the Insolvency and Bankruptcy Code, 2016 (IBC) was enacted, RBI substituted all these existing guidelines with a harmonised and simplified generic framework for resolution of stressed assets through its circular dt. 12 February 2018. It was really simple and strict to administer, with stringent timelines and mandatory referral to proceedings under IBC. But RBI also made the lenders to own up to the scheme by stipulating that ‘lenders must put in place board-approved policies for resolution of stressed assets under this framework, including the timelines for resolution.’

This circular however, was struck down by the Supreme Court on 2 April 2019 on the ground of being ultra vires of section 35AA of the Banking Regulation Act, 1949. The order of the Supreme Court mandated RBI to exercise its powers under Section 35AA ‘in respect of specific defaults by specific debtors.’ Consequently, RBI issued its press release on 4 April 2019 informing that it will issue a revised circular, for expeditious and effective resolution of stressed assets. The press release also stated that ‘The RBI stands committed to maintain and enhance the momentum of resolution of stressed assets and adherence to credit discipline.’ Subsequently, Reserve Bank of India (Prudential Framework for Resolution of Stressed Assets) Directions 2019 was introduced on 7 June 2019, giving fresh directions to lenders on the resolution of stressed assets. Of course, RBI made it a point to repeat that all the earlier schemes (like those listed above) stand withdrawn immediately. As in the earlier framework of 2018, RBI advised lenders to put in place board-approved policies for resolution of stressed assets, including the timelines for resolution. For good measure, RBI added that the robustness of the board-approved policy and the outcomes would be examined as part of the supervisory oversight of RBI. This framework is currently in force.

While issuing the 2019 guidelines, RBI stated that the fundamental principles underlying the new regulatory approach for resolution of stressed assets are:

  1. Early recognition and reporting of default in respect of large borrowers by banks, FIs and NBFCs, to provide a pre-IBC window for banks to resolve stressed accounts. In fact, in this revised framework, RBI specifically introduced a paragraph on ‘purpose’ mentioning that these directions are issued with a view to providing a framework for early recognition, reporting and time-bound resolution of stressed assets. It also added (to conform to legal requirement) that these directions are issued without prejudice to issuance of specific directions, from time to time, by RBI to banks, in terms of the provisions of Section 35AA of the Banking Regulation Act, 1949, for initiation of insolvency proceedings against specific borrowers under IBC
  2. Complete discretion to lenders with regard to design and implementation of resolution plans (RP), in supersession of earlier resolution schemes like S4A or SDR, subject to the specified timeline and independent credit evaluation. Thus, for example, once a borrower is reported to be in default by any of the lenders, lenders shall undertake a prima facie review of the borrower account within 30 days from such default (review period). During this review period of 30 days, lenders may decide on the resolution strategy, including the nature of the RP, the approach for implementation of the RP, etc. The lenders may also choose to initiate legal proceedings for insolvency or recovery.
  3. A system of disincentives in the form of additional provisioning for delay in implementation of resolution plan or initiation of insolvency proceedings. Earlier, accounts restructured under the framework attracted provisioning as per the asset classification category. There was no graded or incremental provisioning linked with delay. Now, where a viable RP in respect of a borrower is not implemented within the timelines, all lenders shall make additional provisions of 20 percent of the outstanding if RP is not implemented within 180 days from end of review period and 35 percent if RP is not implemented within 365 days from the commencement of RP. This is expected to encourage lenders to hasten implementation of viable RPs. The saving grace is that additional provisioning is subject to the cap of 100 percent of total outstanding and there is permission for reversal of provisions in certain compliance situations, such as when RP is implemented or upon filing and admission of the stressed account under IBC.
  4. Withdrawal of asset classification dispensations on restructuring: Future upgrades are contingent on a meaningful demonstration of satisfactory performance for a reasonable period. In particular, if the borrower fails to demonstrate satisfactory performance during the monitoring period, asset classification upgrade shall be subject to implementation of a fresh restructuring/change in ownership under this framework or under IBC. Satisfactory performance has been defined to mean that the borrower entity is not in default at any point of time during the period concerned.
  5. For the purpose of restructuring, the definition of ‘financial difficulty’ has been aligned with the guidelines issued by the Basel Committee on Banking Supervision. The earlier definition was more transactional in nature and hence clearer to administer by lenders such as inability to maintain stipulated margin, drawings exceeding sanctioned limits, periodic interest debited remaining unrealised, significant delay in project implementation etc. Now the definition is more at the conceptual level such as credit facilities are in non-performing status or would be categorised as nonperforming without the concessions, on the basis of actual performance, estimates and projections that encompass the borrower’s current level of operations, the borrower’s cash flows are assessed to be insufficient to service all of its loans or debt securities, etc. This gives freedom to banks to decide rather than specific prescription by RBI, though subjectivity could creep in.
  6. Earlier, banks were advised to form a committee called Joint Lenders’ Forum (JLF) and sign an agreement (called JLF Agreement) incorporating the broad rules for the functioning of the JLF. This was mandatory for accounts where aggregate exposure (fund based and nonfund based taken together) was Rs100 crore or more of an account classified as SMA2 and optional in other cases. Signing of inter-creditor agreement (ICA) by all lenders is now mandatory, which will provide for majority decision-making criteria. This signing is to be done during the review period, to provide for ground rules for finalisation and implementation of the RP in respect of borrowers with credit facilities from more than one lender. The decisions agreed upon by a minimum of 75 percent of creditors by value and 60 percent of creditors by number in the JLF now would be considered as the basis for proceeding with the restructuring of the account, and will be binding on all lenders under the terms of the ICA. The dissenting lenders are assured of the liquidation value. Earlier, under the 2018 framework, all lenders had to agree because, as soon as there was a default in the borrower entity’s account with any lender, all lenders had to initiate steps to cure the default, which was the RP.

Interestingly, there was another committee of heads of a few leading public sector banks which recommended Project Sashakt for resolving stressed assets. This committee was constituted and its report approved by the government (and not RBI). As the then FM said, ‘its objective was to strengthen the credit capacity, credit culture and portfolio of public sector banks.’ Under this project, Inter-Creditor Agreement for Resolution of Stressed Assets was executed by 35 banks and financial institutions. This Inter-Creditor Agreement of July 2018 which was operationalised in December 2018 by the Indian Banks Association, covered the key parameters that were specified by RBI in the New framework. However, not much is heard about this project now, particularly after the new framework by RBI.

Comparison of earlier and present framework

Instead of prescribing a rigid timeline, the new framework gives leeway to banks but disincentivises delay by graded additional provisioning. The 30 days’ review period (instead of being considered default on the first day) gives time to lenders to formulate strategy and work out resolution. Referring to IBC for resolution is not mandatory but is one of the options for the lenders. The new framework applies to (systemically important non-deposit taking and deposit taking) NBFCs and small finance banks besides scheduled commercial banks and all India FIs. The first two are added under the new framework. The Revised Circular also mandates the lenders to make ‘appropriate disclosure’ in their financial statements under Notes on Accounts, relating to RPs implemented. In line with the Supreme Court judgment, the Revised Circular spells out that RBI will have the discretion to issue specific directions to the lenders for initiation of insolvency proceedings against borrowers for specific defaults.

While both the frameworks (2018 and 2019) stated that any action by lenders with an intent to conceal the actual status of accounts or to evergreen the stressed accounts, will be subjected to stringent supervisory/enforcement actions as deemed appropriate by RBI, including, but not limited to, higher provisioning on such accounts and monetary penalties, the earlier 2018 framework had also included ‘any failure on the part of lenders in meeting the prescribed timelines’ as an act by lender, inviting supervisory action. As earlier mentioned, the robustness of the board approved policy and the outcomes are subject to supervisory oversight of RBI now. RBI believes that going ahead, this revised framework of 2019 will induce timely recognition of stressed assets, thus helping in strengthening the financial health of the banks.

Resolution framework and Covid19

Initially, in April 2020, RBI allowed excluding the period from 1 March 2020 to 31 May 2020 for calculating the 30 days’ review period and also allowed extension of timeline for resolution (of 180 days) by 90 days from the date on which the 180-day period was originally set to expire. In May 2020, RBI extended the extension time of 90 days to 180 days. RBI agreed that the framework is a principle-based resolution framework for addressing borrower defaults under ‘normal’ scenario whereas the economic fallout on account of the Covid19 pandemic could potentially impact the long-term viability of many firms, otherwise having a good track record; thus, the situation is no more ‘normal.’ Such widespread impact could impair the entire recovery process, posing significant financial stability risks. Hence RBI decided in June 2020 to provide a special window under the Prudential framework to enable the lenders to implement a resolution plan to borrowers having stress on account of Covid19. This June 2020 circular gives detailed guidelines for handling resolutions for loans to individuals and also others including corporates.

An interesting aspect of this window is that an expert committee has been formed to recommend a list of financial parameters which, in their opinion, would be required to be factored into the assumptions that go into each resolution plan, and the sector-specific benchmark ranges for such parameters. The parameters shall inter alia cover aspects related to leverage, liquidity, debt serviceability, etc. Decades ago, there was a Tandon Committee report, which prescribed suggestive (inventory) norms for fifteen different kind of industries, covering majority of all industries in the country. The present expert committee is also similarly expected to recommend list of financial parameters and a range for those financial parameters for different sectors (now it will be much higher than just 15) as an input for resolution plans under this window. Though no time limit has been stipulated for the committee to submit its recommendations on the parameters, RBI will publish it (with modifications, if any) within 30 days of submission by the committee. The committee is open-ended in time, because it is also responsible to vet RPs under this window where the aggregate exposure is Rs1500 crore or more, which may flow in, for quite some time in the future. RBI has adopted a hands-off approach towards this committee. There are no members from RBI in this committee and even the secretariat for the committee is at the industry body, Indian Banks’ Association and not at RBI. Only the expenses of this committee will be borne by RBI. As of now, this is a work in progress situation and deserves deeper understanding once its report is published.

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