Is the Kamath-proposed restructuring framework effective?

The much-awaited report of the KV Kamath committee has been made public. This report sets the framework for creditors to restructure loans to companies facing stress due to the Covid-19 pandemic and the lockdowns imposed in response to it. Earlier in August, the Reserve Bank of India had issued circulars for restructuring loans to micro, small, and medium enterprises as well as individual borrowers. This report covers loans and borrowers over Rs 25 crore, for which the expert committee was constituted.

There are some clear positives in this report. Specifically, it maintains continuity with the earlier circular in setting initial qualifying conditions for a loan to become eligible for restructuring e.g. that the loan has to be standard and less than 30 days overdue on March 1, 2020. It also clearly states that the objective of this framework is to resolve only those loans suffering from Covid-related stress and not those that were already stressed before Covid. In order to make this focus clear, it presents an interesting 2x2 matrix, based on whether the sector was facing stress even before the coronavirus or not, and whether it was incrementally impacted by the pandemic or not, which effectively classifies sectors into four cohorts. Finally, the framework is simple with only five well thought through parameters that will determine the construct of a resolution plan for the restructured loans. Simplicity will make it easier for the recommendations to be implemented quickly which is critical considering the challenge posed by Covid-19.

There are other noteworthy aspects of the framework that would have significant implications for the banking sector.

Stressed Pre-Covid, Then Hit Further

Loans of about Rs 22.2 lakh crore are in sectors that were stressed even before Covid and were also incrementally impacted by the pandemic. It is obvious that given the pre-Covid stress many companies in this cohort will not meet the ‘not overdue by more than 30 days on March 1’ criterion. Many of these companies would have suffered much greater incremental impact due to the pandemic (e.g. those in aviation) but will not qualify. We could see large NPAs emerging out of this group.

The resolution plan entails a projection of cash flows which will not be easy for many sectors, where the trajectory to return to the pre-Covid levels of business is not clear.

This will be especially challenging for sectors where the pandemic will result in deeper customer behaviour changes e.g. in hospitality, aviation, retail trade, airports, etc. Creditors may take a conservative view which would mean that the resolution plans may not meet the target levels of the five parameters, and restructuring will not be possible. This problem would be especially acute for the cohort which is only impacted by Covid (top left in the 2x2 matrix). The need to project cash flows and meet the thresholds on key parameters will also give managements some flexibility in dealing with individual accounts but should also create accountability for them for the success of restructuring.

Risk In Letting This Become The Norm

The parameter thresholds that the report recommends are generally more generous than what Indian banking uses normally; and also mostly the same across most sectors with exceptions made for only the extreme cases such as aviation for current ratio and real estate for leverage. Also, the resolution plans are expected to deliver these thresholds by FY23.

The risk of being so prescriptive with the threshold is that they become the new normal.

Given that they are more liberal than the practice, there is a risk that weaker financial conditions could be legitimised through the resolution plan. It may have been better if the threshold prescribed in the report were to be the target just for the resolution plan, and eventually the creditors are encouraged to achieve the pre-Covid level, or those prescribed in their internal risk policy. The framework could ask the resolution plan to reach the threshold levels by FY23 but then further reach the pre-Covid levels in a defined time period after that. Such a requirement would ensure that these thresholds do not become the new normal.

We assume that the RBI will ask banks to draft their own policies of restructuring within the boundary conditions imposed by this report so that banks could take a nuanced view and make the requirements more stringent to avoid restructured loans turning bad. It is also quite likely that many banks will take the recommendations of the report as they are and adopt them as policy. With such banks, the risk of these thresholds becoming the new normal is significant.

The Aug. 6 circular that RBI issued specifically excluded non-banking financial companies from restructuring. This report identifies NBFCs as a sector that was stressed before Covid and has also been impacted by Covid. NBFCs and housing finance companies account for nearly 8% of bank loans and have been facing several challenges since late-2018. There is clearly a need to have some formal regulatory guidance on how to deal with stress in this sector.

There are some minor anomalies in the report. Some sectors that are mentioned in the table but are not mentioned in the 2x2 matrix (e.g. logistics) so we don’t know which cohort they fall into. 

Parameters have been defined for sectors—like pharma manufacturing, FMCG—that fall in the cohort which was neither stressed pre-Covid nor has been impacted by Covid, and hence should not need restructuring.

Disclosures And Accountability 

RBI has also issued a formal circular based on the recommendations from this report. While this circular does not explicitly detail disclosure requirements, we should assume that those outlined in the Aug. 6 circular for the restructuring of MSME and individual loans would also apply to the restructuring of the large accounts envisaged in this circular. It will be critical that creditors make extensive disclosures so that the stakeholders can credibly assess the impact of restructuring. It will also clearly establish the accountability of bankers for the restructuring decisions. It would also be useful if the RBI also instructs banks to impose conditionalities on the borrowers seeking restructuring so that the customers of the restructured loans also have a stake in the success of the resolution plan. Specifically, conditionalities relating to constraints on the discretionary use of cash flows would be important – e.g. buyback, delisting, acquisitions, dividend payments, etc.

Notwithstanding some of these issues, the report marks a good beginning to the challenging task of dealing with the impact of Covid-19.

Authored by

Harsh Vardhan, Executive in Residence, Financial Studies - SP Jain Institute of Management and Research

Shishir Mankad, Practice Leader - Financial Services

The article was first published on BloombergQuint.