Should RBI have a re look at risk weights in corporate lending?

  Risk Weights on loans to Corporates and NBFCs: 

External ratings based concept deserve a relook

Recovery in Corporate Loans: Mr. Bhagwad Karad, Minister of Finance informed Parliament last week, that while Rs.10.42 lac cr. loans were written off during the period 2014-15  to 2022-23, the recovery from the written off accounts was Rs.1.61 lac cr. in the same period. The following is the gist of information provided:

• 50% of the Rs.10.42 lac cr. written off in the above period relate to large corporate houses
• Wilful defaulters, having loans of Rs.5 cr. and above, defaulted around Rs.2 lac cr.
• The recovery from written off accounts in aggregate is less than 20% of the outstanding

History: In this regard, it is worthwhile to recall that in respect of the insolvency proceedings initiated against 40 companies under the RBI’s 1st and 2nd List, barring few exceptions like Bhushan Steel and Essar Steel, the amount realised by the banking system was not in excess of 35% of the total amount due from the defaulted borrowers. While asset-heavy companies and loan proceeds used for creating tangible assets had a few takers, corporates, which had heavy debts, with no assets to back up, could not pass through the resolution route. In a few cases, the resolution plan from a single bidder, which quoted marginally higher than liquidation value had to be accepted. No one is able to say, yet, with firm conviction that the same history may not be repeated again and the lenders have since strengthened their credit appraisal, disbursement, monitoring skills. After the Kingfisher Airlines episode, Jet Airways, which is still in the process of revival, thanks to the resolution plan approved, could fetch hardly 10% of the total over dues to the financial creditors. A third airline is in trouble now and it will be a miracle if the airlines is revived/the lenders escape with no major haircuts in their books. IL&FS, SREI and some companies that belong to Anil Ambani promoted Reliance group are still under the process of resolution plans, with no apparent chances of the recovery being more than 40%. Last year, the stock prices of the several corporations of one of the largest conglomerates saw huge fluctuations, causing apprehensions in the minds of investors and lenders on the safety of money invested/lent. Though there were brave statements like "we have nothing to worry, our finance is based on cash flows", no one came out further with whether their advances are backed by solid tangible assets or the said cash flows were based on actuals in the past or projected ones based on assumptions about future. 

Whether this can be curtailed? Possibly yes, if we can bring some changes to the risk weights assigned to exposures to corporates/NBFCs, which is now purely based on external credit ratings from approved credit rating agencies. Let me explain.

1. Risk Weight on loans calculated for arriving at credit risk to calculate capital adequacy ratio: At present banks finance medium enterprises/corporates/NBFCs in different ways like project loans, working capital advances, term loans for boosting working capital purposes, term loans for general corporate purposes and also extend non fund based limits like letters/lines of credit/comfort and guarantees. Personal, SMEs and agricultural loans carry risk weights depending on whether they are regulatory retail/secured/unsecured (varying between 35/50/75/100/125/150%). However, medium enterprises/corporates and NBFCs@ carry risk weights based on their external credit ratings (obtained from approved credit rating agencies). If they are not rated, unrated risk weight is applicable. Irrespective of the security available/asset created out of the loan proceeds, the risk weight on long term claims is uniform across corporates/NBFCs  

- at 20% for AAA rated, 30% for AA rated. 50% for A rated, 100% for BBB rated and 150% for BB and below. (100% for unrated corporates)

Same type of concession on risk weight is available on short term claims on corporates/NBFCs based on external credit ratings.

Again if the default history of corporates is an indication, there are many instances where AAA/AA/A rated (some of which obtained their ratings based on the strengths of their group/assumption of continued support from group companies) turned in to D (default grade) status overnight.

2. Provision requirements is favourable for standard advances at not exceeding 1% (5% only for restructured advances) and even substandard assets  carry 15/25%: So stringent provisions kick in, only when the asset becomes doubtful - that is, after a loan remain in stressed category for a period exceeding 15 months. (Only in the case of a doubtful asset, a bank has to provide 100% provision for  an unsecured advance)

My suggestion: 

Supplement risk weights based on external credit ratings for loans to corporates/NBFCs with added weights for exposures given for less/non tangible asset creation. One should acknowledge the fact that availability of tangibles, assured set cash flows based on the past, guaranteeing viable continued business proposition played a major part in the ultimate recovery percentage through resolution/liquidation. While RBI (Reserve Bank of India) is not expected to micro manage on how the banks should lend or their ways of corporate lending, taking into account the advantages enjoyed by loans backed by tangible assets over the other type of loans at the time of recovery, it will not be a bad idea if the regulator brainstorm, as to whether additional risk weights have to be imposed in respect of corporate/NBFC advances, which are unsecured or which do not add value to the existing tangible assets*. 

Regards.

V.Viswanathan

20th December 2023.

*Banks financed a famous airlines in the past against their brand value. While this was well accepted norm to finance during good times, the value became zero, when the loan became stressed and turned negative, when the operations came to a halt.

@Core Investment companies (CIC), whether rated or unrated, carry 100% risk weight