We study each firm for a five-year period, two years before and two years after the CDR reference year, and the reference year itself. We assign scores to firms based on their distress levels. Firms with interest coverage ratio (ICR) less than 1 are assigned a score of 1. These firms do not have the capacity to repay their interest, which is an incipient sign of distress. Firms with ICR less than 1 and negative cash profit are assigned a score of 2. These are loss-making firms, which are clearly distressed. Finally, firms with ICR less than 1, negative cash profit and negative net worth are assigned a score of 3. The liabilities of these firms exceed their assets and they are highly distressed. All other firms are considered financially healthy and assigned a score of 0.
In our analysis we find four main results. First, firms’ distress levels did not get alleviated in the post-CDR period, in fact they worsened. Of the firms that had a score of 0 or 1 in the CDR reference years, more than 80 per cent worsened to score 2 and score 3 categories two years post CDR. More than 50 per cent of the firms that had a score of 2 worsened to score 3. Among the largest bank borrowers, 16 firms were highly distressed in the CDR reference years. Only three of these showed an improvement in their score post CDR. We get the same result when we look at three years post-CDR.
Second, despite more firms becoming financially distressed in the post-CDR period, banks continued to lend to them. More than 70 per cent of bank borrowing in the post-CDR period was accounted for by highly distressed (scores 2 and 3) firms. Banks extended a higher amount of financing to distressed firms than to relatively less distressed ones (scores 0 and 1).
Third, while these firms continued to receive bank financing, their distress levels did not go down. This evidence points to the fact that the nature of financial distress in these CDR firms was not temporary and many of them might have been economically unviable.
Finally, we find that the leverage of these firms increased in the post-CDR period and the proportion of bank borrowing to total borrowing of these firms also remained high. In other words, these financially distressed firms did not de-lever, and their leverage increase came primarily from additional bank borrowing.
Our results point to the fact that banks, incentivised by the RBI’s regulatory forbearance, were using the CDR mechanism to prevent loans to distressed firms from becoming NPAs. Ideally, banks should have followed an “adjustment strategy”, fully providing for NPAs coming from highly distressed firms. This might have reduced banks’ profits early on, but would have subsequently led to higher recoveries, with firms getting restructured. Instead, banks chose the “financing strategy”. This further increased the leverage of distressed firms, aggravated the stress in corporate and bank balance sheets, and created the twin balance sheet crisis we are witnessing today.
The finding that banks have been throwing good money after bad is particularly important against the backdrop of the recent Banking Regulation (Amendment) Ordinance, 2017. The Ordinance empowers the RBI to direct banks to initiate restructuring mechanisms against defaulting firms. In doing so, it is critical that the “financing strategy” does not get repeated.
An effective restructuring mechanism has three components. First, there needs to be an independent assessment of firm viability prior to restructuring. This failed in CDR where banks, which were affected by CDR outcomes, were also the decision-makers. Second, regulatory forbearance vitiates the incentive for viability assessment, which is a commercial decision, and should not be granted. Third, the presence of a formal insolvency process imposes discipline on informal restructuring mechanisms. Lenders informally restructure only those firms where they are likely to recover more than in the formal process, and borrowers cooperate with lenders or face liquidation as part of formal bankruptcy. In India today, one out of these three elements is in place in the form of the Insolvency and Bankruptcy Code, 2016. To ensure the effectiveness of any restructuring mechanism that banks may now be directed by the RBI to pursue, the other two elements are crucial.
Sengupta is assistant professor of economics, IGIDR; Sharma is consultant, Finance
Research Group, IGIDR
Published with permission from Ideas For India (www.ideasforindia.in
), an economics and policy portal. A version of this appeared on I4I.