14/06/2016 7:06 PM IST | Updated 15/07/2016 8:27 AM IST

Why RBI's Debt-Equity Swap Scheme Is Good News For Indian Banks Saddled With Bad Loans

Joshua Roberts / Reuters
Governor of the Reserve Bank of India Raghuram Rajan speaks at a forum on financial development at the 2016 IMF World Bank Spring Meeting in Washington April 17, 2016. REUTERS/Joshua Roberts/File Photo

The bad debt crisis at Indian banks is likely to continue for sometime, at least until the banks have purged their balance sheets of non-performing debt--a mandate Reserve Bank Of India governor Raghuram Rajan has described as “deep surgery.”

However, the exercise is proving far more painful as each markdown has lead to strained balance sheets, in what SBI chairman Arundhati Bhattacharya earlier this week likened to “going to war with bare hands" with no weapons.

In the latest move to help banks deal with their stressed assets, RBI has issued guidelines to help banks identify opportunities to convert up to half of their non-performing debt positions in indebted companies into equity, should the borrowers meet certain criteria that would determine if their debt is sustainable in the long-term. Under RBI's ‘Scheme for Sustainable Structuring of Stressed Assets,’ the conversion into equity or quasi-equity instruments could provide an incentive to lenders to share in the profits should the indebted company turn around, according to an RBI note.

So what types of bad debt situations are eligible for this provision? Stressed debt related to all commercially operational entities that owe more than Rs500 crore to lenders, including interest, would qualify. Additionally, their debt should also meet RBI’s test of sustainability which includes:

- The ability of the indebted company to service the term of all its debt with its current cash flow, even if the future cash flows fail to increase.

- The sustainable debt portion should make up more than half of all the debt owed.

Once the sustainable debt has been worked out, the banks and borrowing companies can evaluate various recapitalisation scenarios with the help of an external agency. The equity portion of the deal will have to be "marked to market," or deemed at fair value, according to the RBI note.

Banks would also have to follow certain terms and conditions that will govern the sustainable debt portion -- such as one that would prohibit them from extending the repayment schedule of the loans, or otherwise amending loan terms, according to the note. Other caveats and conditions can be found here.

To be sure, banks have had the option to convert their debt into equity in the past, but the procedures have been somewhat onerous in India that would allow banks to take “haircuts,” where a lender agrees to a loan repayment less than what is owed.

The latest move is good news for banks as they have another option and framework at hand to resolve their bad debt mess, according to Srikanth Vadlamani, a senior analyst with Moody’s Investors Service.

“It is an enabling provision” for the banks, Vadlamani said, adding that this move should not be seen as an accounting leeway.

It could also pave the way for distressed debt investors to play in the Indian market where lenders have been reluctant to take "haircuts" on their debt positions due to differences over pricing. A number of international stressed debt investors like WL Ross & Co., Oaktree Capital Management, and Apollo Global Management, have already begun evaluating opportunities in the stressed assets space in India, according to media reports.

Last week, Moody’s said in a report that stressed Indian public banks will need ₹1.2 trillion rupees ($18 billion) in capital through 2020, about more than double the capital the government plans to inject into them.

While Indian banks are facing solvency related challenges, they remain very comfortable on the liquidity front. Hence, we see the chances of a systemic banking crisis being remote"

Asked if India’s current bank debt problems pose a grave risk to the economy, Vadlamani said, "while Indian banks are facing solvency related challenges, they remain very comfortable on the liquidity front. Hence, we see the chances of a systemic banking crisis being remote”.

Banks have had to clean up their balance sheets and report non-performing assets (NPAs) or bad loans as part of a massive clean-up drive, also known as ‘asset quality review,’ which was prompted by RBI last year. The move led to a number of banks running into heavy losses.

Debt equity swaps have been tried in other markets, too. Earlier this year, Chinese officials indicated they would encourage market-oriented debt-equity swaps to help Chinese banks reduce their corporate indebtedness.

David Brown, a partner at PwC in Hong Kong, wrote in the Financial Times, "banks are not motivated to write down their loans if they get nothing back in return... Allowing banks to take an equity stake in return for writing off some portion of their loans (they will rarely convert all) enables the banks to share in any upside. In successful cases, the equity upside could exceed the amount of the original loan."

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