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Event update: Financials - New stress resolution framework; No one-day default, but additional provisioning is a negative

RBI has come up with a new stress resolution framework after the Supreme Court struck down the Feb 12, 2018 circular. Lenders have the freedom to work on any resolution plan to resolve stress loans including NPLs. Banks have to review stress loans within 30 days of default and implement a resolution plan in 180 days thereafter – so a total of 210 days for resolution. If the resolution plan is not implemented in 180 days after the review period, banks will have to make penal provisions. It appears that resolving bad loans under the IBC may still be the best option for banks even after this circular. We believe Rs3.6 trn of stress loans are immediately impacted by this circular of which Rs2.6 trn are standard and Rs960bn are NPLs. If we include debt of government backed borrowers - SEBs (3.2trn) and Air India (250bn excluding transfer of working capital loans of Rs294bn to an SPV) - the figure of impacted loans works out to 7 trn. For our calculations, we have excluded government-backed borrowers. The circular immediately applies to loans above Rs20bn including outstanding NPLs that are unresolved as on June 7, 2019.

As background, the Supreme Court struck down the stress loan circular issued by RBI on Feb 12, 2018. The SC termed the circular as unconstitutional because the regulator was directing banks to refer accounts under the IBC whereas  the bankruptcy code requires that accounts need to be  referred under  the IBC only by banks or the debtors themselves not by the regulator.

How the new circular differs from the old circular:

• Lenders get 30 more days in the debt resolution process, one day default norm cancelled. Under the Feb 12 circular, lenders had to start resolving on day one after default and if the resolution plan could not be implemented in 180 days, the account had to be mandatorily referred to the NCLT. In the new circular, banks get a review period of 30 days after the account defaults (becomes SMA-0) and then 180 days to implement the resolution, so a total of 210 days.
• Penal provisions if resolution fails: Under the old circular if banks could not implement a resolution plan in 180 days, the account had to be referred to NCLT. Under the new circular, if the resolution plan is not implemented in 210 days from the date of default, banks have to make accelerated provisions.  If the resolution plan (RP) is not implemented in 180 days from the end of review period banks will have to provide an additional 20% and if the RP is not implemented within 365 days another 15% (cumulative 35%). Penal provisions will be over and above the existing provisions that banks carry on the loans and will be capped at 100%. So the provisioning is an additional burden and will have to be made even if banks carry excess provisions under IRAC norms. For instance SBI has already made 50% provisions on Samadhan accounts. Even so, if these accounts remain unresolved in the  next 7 months, SBI will have to make additional 15% provisions.
• All lenders have to mandatorily enter into an inter-creditor agreement for each individual borrower under the new circular which was not the case with the old circular.
• The new circular applies to term finance institutions, systematically important NBFCs and small finance banks in addition to scheduled commercial banks which was not the case earlier.
• 75% of lenders by value need to approve the resolution plan under the new circular. Under the old circular, it was 100% which was a big roadblock to resolutions.
• Like in the old circular, if resolution requires restructuring, the account will be downgraded to non-performing category.
• In the new circular, loans can be upgraded only when all the outstanding loan / facilities in the account demonstrate ‘satisfactory performance during the period from the date of implementation of RP up to the date by which at least 10% of the sum of outstanding principal debt as per the RP and interest capitalisation are repaid. In the old circular the 10% repayment clause was higher at 20%. This circular will result in faster upgrades of NPLs if they perform.

The circular incentivises banks to use IBC rather than outside-IBC resolutions: Half of the additional provisions made may be reversed on filing of insolvency application and the remaining additional provisions may be reversed upon admission of the borrower into the insolvency resolution. As such the circular incentivises banks to refer loans to the IBC while the old circular made such referrals mandatory. Past experience shows that top management of state owned banks are reluctant to approve outside-IBC resolutions involving big haircuts and prefer the IBC route because every resolution in the IBC is court approved.

Earnings impact – credit cost will rise: The earnings impact can be broken down into two parts based on the penal provisioning – 7 months from now and 1 year from now. Given that the historical pace of resolution has remained slow, the earnings impact from this circular will be high as banks may not be able to meet the 180-day deadline. The pre-tax impact can be of the order of 47 bps of loans in the next 3 quarters (7 months) and 82 bps of loans (after a year) based on our assumptions.

Quantum of loans that will be impacted by the circular: We calculate that NPLs of at least Rs960bn mainly from the power sector and standard stress loans worth Rs2.6 trn will be impacted by this circular. State banks likely have a larger share of the stress compared to the large private banks. The table on the following page gives an indicative list of companies impacted.