Mumbai: Banks in India must improve pricing of loans based on risk assessment, a skill that would have helped them avoid non-performing assets, said N.S. Vishwanathan, deputy governor of the Reserve Bank of India on Thursday.
He also asked banks to improve underwriting standards by writing strong loan covenants—agreements with the borrowers—as well as enforcing them on time.
Indian banks are currently sitting on a stressed asset pool of over Rs10 trillion.
“Risk-based pricing of loan would need fair assessment and understanding of the risk involved, rather than merely relying on collateral and/or guarantees obtained from stakeholders including equity holders. Banks should charge interest rate that is commensurate with the risk involved in the projects that are being financed,” he said at an event.
In many instances, risk is under-priced, he said.
“It would be safe to assume that had proper risk pricing been done by banks, many of the current NPAs (non-performing assets) could have properly assessed very well in advance,” he added.
According to Vishwanathan, risk-based pricing will help lenders build buffers that will act as cushions in case certain projects become non-performing assets. Such assessment must also be in sync with the stage of business cycle where the borrowers operate.
Enforcing loan covenants along with proper risk pricing and early recognition of stress must be embedded in credit culture of banks, he said.
Early recognition of stress has assumed even more significance under the resolution mechanism of Insolvency & Bankruptcy Code (IBC). This is because the IBC has strict timelines for resolution; else, the asset is liquidated.
“In IBC, the possibility of equity holders losing an entity should result in both stakeholders, creditors as well as debtor, to work towards resolution that is best for them. Both of them have an interest in keeping it in going concern. Therefore, coordination mechanisms among banks, through institutional platform like joint lenders’ forum (JLFs) must ideally deploy before the account is classified as special mention account (SMA),” he said.
RBI has mandated banks to form JLFs when the account is classified SMA-2.
When the principal or interest payment for a particular loan is overdue between 61 and 90 days (and not exceeding 90 days), this is called special mention account-2 or SMA-2.
“Use of covenants in monitoring loan exposures can reduce stress and time to recovery. A covenant remains a simple, but an often ignored tool in the Indian context and could be used more effectively to avoid a repeat of the asset quality problems facing the Indian banking system,” said Udit Kariwala, senior analyst, financial institutions, at India Ratings.
According to India Ratings’ analysis of 83 stressed corporate borrowers with a debt of Rs5.1 trillion (classified as default by at least one rating agency by 31 May 2016), had banks restricted incremental debt to companies using the efficacy of covenants, the time to recovery from organic cash flows would have been half of the current levels of 19 to 24 years. In certain cases, the stress could have even been avoided.livemint