In simple English, what Das said was that the negative economic impact of covid-19 will lead to increased defaults by borrowers. How bad is it going to get? If one-twentieth of the loans which are likely to be under a moratorium as of 31 August are defaulted on, the overall quantum of bad loans in the Indian banking system would be close to ₹12 trillion. If one-fifth of them default once the moratorium is lifted, the quantum of bad loans would touch a dizzying ₹20 trillion, more than double the current level.

These are extremely conservative estimates, of course. Not surprisingly, former RBI governor Raghuram Rajan said recently: “The levels of NPA will be unprecedented six months from now.”

With increased defaults, banks will need to be recapitalized, that is, more money will have to be invested in them to keep them going. In fact, there is already enough evidence of increased pressure in the banking system in the days ahead and of the impending storm.

Size of the hole

As per the rating agency ICRA, 52% of assets under management of non-banking finance companies (NBFCs) were under a moratorium as of May 2020. Even if 10% of these loans are defaulted on, the gross NPAs of NBFCs will more than double and reach 9.6% of loans as of March 2021. They were at 4.6% as of March 2020. Gross NPAs, also referred to as bad loans, are basically loans which haven’t been repaid for a period of 90 days or more.

Any trouble at the level of NBFCs is likely to spill over to banks. Post demonetization, banks had a surfeit of money coming in as deposits, which found its way into the shadow banking sector. As of December 2016, bank lending to NBFCs had stood at ₹3.22 trillion. By May 2020, the lending had jumped to ₹8.04 trillion. Hence, if NBFC borrowers’ default, NBFCs will find it difficult to repay bank loans.

A Bloomberg news report published in early July points out that the rating firms have submitted a document to RBI where they have suggested that they will have to stop publishing credit scores of many companies which haven’t been providing adequate information or have stopped paying the fees to rating firms. This could potentially impact nearly half of the companies which currently go through a regular rating exercise. Hence, many companies are in trouble and want to hide that by not sharing information. Clearly, in the months to come, many of these firms will not be in a position to continue repaying their loans.

A recent report in Mint points out that between April and end-June, 5.58 million salaried-individuals withdrew money from their Employees’ Provident Fund account, suggesting a steep fall in incomes. Hence, many individuals are no longer in a position to continue repaying the loans that they had taken from banks as well as NBFCs. The only reason they haven’t started defaulting is because until 31 August, they can opt for a moratorium on their loans. But defaults will explode September onwards.

In general, private banks have put almost all new recruitment on hold. But they continue to recruit people in their loan-recovery functions. This is a clear indication of the fact that they are gearing up to handle increased retail loan defaults. The trouble will be more on the unsecured lending front, essentially loans like personal loans, consumer durable loans and credit card outstandings.

The timeline

Given that the lockdown started in late-March, bad loans should have already started piling up by now. But that hasn’t happened, thanks to the moratorium. Hence, banks will start categorizing loans as bad loans only 90 days after 31 August, that means 1 December onwards.

In a 3 June report, Suresh Ganapathy, Parth Gutka and Nishant Shah of Macquarie Securities estimate: “Currently 20-30% of the loan book is under moratorium. The… initial signs based on the feedback from banks and consultancies is that by end-August, more than 50% of the loan book could be under moratorium.”

In another report dated 30 June, Kajal Gandhi, Vishal Narnolia and Yash Batra of ICICI Securities write: “In terms of (the) moratorium trend, public sector banks reported approximately 40-50% of the book under moratorium… Mid-sized private banks reported higher moratorium above 50% due to substantial exposure to MSME, auto and MFI segment, which were the most impacted. In contrast, the moratorium book of large-sized private banks was relatively lower at about 20-30%.”

Hence, it is safe to assume that by 31 August, around half of the bank loans will be under a moratorium. As of 19 June, the total non-food credit of commercial banks had stood at ₹101.56 trillion.

The Food Corporation of India along with state procurement agencies buy agricultural crops, primarily rice and wheat, directly from farmers. Banks finance this purchase. Once these loans are subtracted from overall loans given by banks what remains is non-food credit.

Keeping in mind the slow growth in credit over the last few months, let’s say the non-food credit increases to around ₹102 trillion by 31 August. If half of these loans go under a moratorium, that would work out to loans worth around ₹51 trillion. Even if just 5% of the loans expected to be under moratorium are defaulted on, then we are looking at additional bad loans worth ₹2.55 trillion. At 5% and 10% default rates, the additional bad loans will amount to ₹5.1 trillion and ₹7.65 trillion, respectively. At a 20% default rate, we are looking at additional bad loans worth ₹10.2 trillion.

It needs to be said here that opting for loans to be put under a moratorium comes with a cost. The interest due on the loans for the period they were under a moratorium will be added to the principal outstanding and a borrower will have to repay a higher amount. Also, it needs to be said here that most banks gave borrowers the option to opt-in for the moratorium.

Hence, only borrowers who would be really stretched for money would have opted for a moratorium. Given this, the chances that a good number of them will default are high.

As the analysts at Macquarie quoted earlier point out: “If we assume 20% of the loan book under moratorium going bad, then non-performing loans (NPLs) accretion will be at 10% implying that NPLs will double from current levels of 10%.”

The rescue plans

It needs to be pointed here that banks have been dealing with a massive problem of bad loans over the last decade. As of 31 March 2018, the bad loans of Indian banks had peaked at ₹10.36 trillion. Thanks to recoveries and write-offs, the bad loans as of 31 March 2020 amounted to ₹9.4 trillion (as per ICICI Securities). The bad loan rate was at 9.4%.

Hence, if 20% of the loans expected to be under moratorium are defaulted on, another ₹10.2 trillion will be added to the bad loans. Therefore, total bad loans will amount to close to ₹20 trillion or 20% of the banking loans. Even if just 5% of loans expected to be under a moratorium are defaulted on, we are looking at overall bad loans of around ₹12 trillion and a bad loans rate of 12%.

Over and above this, as Ananth Narayan of SP Jain Institute of Management and Research wrote in the Mint in early June: “For a while now, RBI has allowed banks to postpone non-performing asset recognition for some of the over ₹8 trillion of MSME, MUDRA and commercial real estate loans.” If we take this into account, the overall picture gets even more scary.

In a world where the rate of recovery of bad loans was high, this wouldn’t be a big problem. But the rate of recovery through various channels has fallen over the years. In 2012-13, around 22% of the amount that was sought to be recovered through various mechanisms was recovered. By 2018-19, this had fallen to 15.5%. And this is despite the Insolvency and Bankruptcy Code coming into the picture.

Given this dire scenario, it is not surprising that RBI governor Das is already talking about a recapitalization plan for banks. It is hardly surprising that the biggest private banks are already in the process of raising more capital to be ready for the time when the loan defaults start to hit. An ICICI Securities report dated 15 July estimates “greater than US$20bn ( ₹1.5 trillion) of equity raising by banks… over the next 12-18 months.”

This also means that the bureaucrats at the department of financial services, which is responsible for public sector banks, must wake up to the possibility of raising more capital for these banks. The trouble is, if the government wants to continue to maintain its ownership level in these banks, then it needs to invest more money in them. And right now, it’s terribly short of money.

Since October 2017, the government has worked its way around this problem by issuing recapitalization bonds. The government issues bonds which are bought by the PSBs. The government then uses this money to invest in the PSBs and provides them with capital. Basically, this is how government borrows money from banks and converts it into capital.

This is fundamentally nothing but an accounting trick, which ensures that the government doesn’t end up putting money earned through taxes into the PSBs. Since October 2017, more than ₹2.5 trillion worth of these bonds have been issued.

The way ahead

It’s time the government got around to the idea of diluting its stake in PSBs up to 33%, something that the then finance minister Yashwant Sinha had talked about in the budget speech he made in February 2000. This will allow PSBs to raise real capital from the financial market. Of course, all this will happen only if the government of the day wants this to happen.

To conclude, if the experience of the last decade is anything to go by, what is likely to happen is that the can will be kicked down the road.

By 2011, it was largely clear that PSBs were in trouble, thanks to the lending binge they had indulged in between 2004 and 2011. But the clean-up only started in mid-2015 when Rajan, the then RBI governor, started the asset quality review of banks.

Up until then, the Reserve Bank of India had tried to practise what it called regulatory forbearance and showed restraint. It came up with several restructuring schemes allowing banks to increase the tenure of the loans or decrease the interest rate charged. In some cases, new loans were also given so that corporates could repay the old loans which were due. All this helped banks postpone the recognition of bad loans.

The idea behind this was that the banks would manage to grow out of this by giving out new loans and ultimately bad loans would become a very small part of the overall loans. Of course, that didn’t happen.

From the looks of it, the practice of kicking bad loans down the road is likely to be followed this time around as well. There is already a lot of talk going around about the finance ministry and RBI discussing a one-time restructuring plan.

Of course, in the environment that will emerge, many banks won’t like giving fresh loans, and individual and corporate borrowing will take a backseat as well. Hence, the interest on bank deposits will go down further. That’s the minimum cost you and I will bear for this upcoming banking crisis. As they say, in economics, there is no free lunch.

Vivek Kaul is the author of Bad Money—Inside The NPA Mess And How It Threatens The Indian Banking System