Lending to EPC Sector in Troubled Waters

The gross Non Performing Assets (NPAs) of banks in India were Rs.3.23 lakh crore (USD 48 bn) as on March 31, 2015 as per RBI, and estimated at approx. Rs. 6 lakh crore (USD 88 bn) as on March 31, 2016. The NPAs are mainly in infrastructure sector, textile, iron & steel etc. As per various reports the growth rate of Indian economy is projected at 7% for FY 2016-17. However, the credit growth rate in the country has declined in infrastructure and manufacturing sector as lenders are struggling with growing NPAs. Infrastructure sector forms a major part of bank credit with share of 36 per cent (as on November 2015). Of which Road & Other infrastructure forms 30 per cent of the bank credit. The peaking levels of NPAs have cautioned banks in selective and conservative lending approach. Government of India is putting efforts for revival of Economic scenario by way of several reforms. In road infra sector, 10,000 Km of highway contracts worth Rs. 1 lakh crore (USD 15 bn) were awarded and 6000 Km were constructed in 2015-16. Government has targeted to award 25000 Km and construct 15000 Km for 2016-17. This would result in award of contracts worth Rs.2.50 lakh crore (USD 37 bn). The government has set target to increase the per day road construction from 20 Km to 40 Km. The newly introduced Hybrid Annuity Model (HAM) is reviving the interest of developers/contractors in the road projects.

The Ministry of Railways is working on several projects that includes modernization/ renovation of railway stations, tracks, faster trains etc. having expenditure of Rs.8.6 lakh crore (USD 127 bn). The Indian Railways has rolled out plans to redevelop 400 stations. The Ministry of Railways will be also taking up 21 port-rail connectivity projects, at an estimated cost of more than Rs.20,000 crore (USD 3 bn), under the port-connectivity enhancement objective of Sagarmala, the flagship programme of the Ministry of Shipping. In addition, another six projects are being considered by the Indian Port Rail Corporation Limited (IPRCL). The Aviation Ministry planned to improve and modernize the airport infrastructure in the country. To boost air connectivity, the government has planned to revive 160 airports and airstrips, each of would cost about Rs. 50-100 crore (USD 7 – 15 mn). Government has planned to develop 200 low cost airports for connecting tier II & III cities. Airport Authority of India (AAI) has planned to invest Rs.15,000 crore (USD 2.20 bn) over the next four years in the development and upgradation of airports. Government's vision of creating 100 smart cities will require an investment of over USD 150 billion over the next few years.

All the above upcoming projects provide enormous opportunities of growth for the EPC/Construction sector. Going with the scope of growth available, the companies in the sector would require fund based and non fund based facilities from banks for undertaking these projects. Having experienced the large scale of NPAs from the infrastructure/EPC sectors, it creates a challenge for banks to meet needs of EPC sector.  In light of this, it is important to visit some of the prudent practices which could help in constructive lending to the EPC sector while mitigating the risks of defaults.

Monitoring Project Progress

The time has gone when the lenders used to issue Bank Guarantees (BGs) and remain under the impression that being EPC project, the BGs will get returned on completion of the project. In many of the cases, it has been seen that the beneficiaries stipulate onerous clauses in the guarantee formats which prevent auto reduction of liability under the BG with the achievement of progress of project. Many a time justifications are provided that performance BG requirement is linked to complete product delivery and cannot be reduced with the intermediate milestone achievements. While accepting such logics, banks need to remember that they should be providing the performance BG related to contractor’s performance, his capability to complete a project with the required standards, based on the detailed analysis of his strengths, past track records, years of experience, credibility and reputation achieved in the field, but banks are not institutions to provide the product performance insurance in the disguise of performance BG.  Remember, there is huge difference in cost of insurance premiums and BG commissions. Inflexibility of project authority is another prime reason which is sighted for insertion of onerous clauses/deletion of mandatory clauses. Such stubborn practices are not good for the long term progress of the sector. With the changing time, it is imperative for lenders to regularly monitor the progress of the projects. Lenders need to have regular update on the progress of project and milestones achieved. Such reports can be submitted by borrowers along with monthly stock/receivable statements. Many such reports/details are generally ready with contractors as they also maintain project progress status for billing/accounting/taxation and various other purposes. Since delays may cause increase in project cost and if the same are not condone by the project authorities, it may thereat invocation of bank guarantees.

Depending on the size and exposure to the projects, consortium lenders may decide to appoint Lender’s Independent Engineer (LIE) for providing quarterly/half yearly update on the projects. When a small housing loan is processed, banks send independent valuer to the project site for report on the physical progress of the project. After sanction of home loan, before each disbursement also valuer revisits the project site and submits report on further progress made. Based on such reports, home loan disbursements are made. Taking this as basic concept of prudence, it is important that bankers as a community may adopt the practice of obtaining independent project progress reports.

Interactions with the Project Authorities

In my experience, I have seen that visiting the project sites from time to time gives a real understanding of the project, progress made and provides opportunity for interaction with the project authorities and project team of the borrower/contractor/sub-contractors. This exposes us to the ground level reality of the development, issues involved, satisfaction of the project authorities with the work being done by the contractor. Periodic visits help in seeing the real progress made at the project. It provides opportunity to have a one to one dialogue with project authority helping in understanding whether the project is moving as per the timelines or there is likelihood of extension/penalties which may affect the BGs issued, and liquidity of the contractor.

Milestone Based Bank Guarantees

It is seen that when borrowers submit single bank guarantee for the entire contract, it causes in incurring commission for the entire value and period. With the achievement of project milestones, the requirement of BG value also reduces, however pursuing the project authorities approving reduction in BG value is a herculean task. Therefore, borrowers need to negotiate with the project authorities at the inception only for allowing multiple BGs having different values and periods linked with project milestones (value and period). This supports in easy cancellation of BGs with the achievement of project milestones, unlocking the BG limits and saving of cost.  

Project Specific Limits

Banks sanction open ended fund based and non fund based working capital limits to EPC companies generally without limiting to any specific project. Learning from the past experiences, it would be prudent that while a portion of the overall limit may be carved out for general bidding purpose, banks need to strive for approving project specific limits for contracts awarded to the borrower. Carving out of project specific limit would automatically lead to the requirement of detailed assessment of the project as well periodic monitoring. Such practice would help in better understanding and control of the project performance, and risks/issues involved.     

Building up Margins

Implementation of projects in infrastructure/construction sector depends on many factors involving various clearances like right of way etc. The BGs issued also have to be extended by the contractors due to delays in getting these approvals. As many of the projects come in hinterlands, IBA approved transporters are also sometimes not available in these project areas for supplies/transportation of materials. Apart from this, as mentioned earlier, the inflexible nature of project authorities also leads to waiver of prudent mandatory clauses, or insertion of onerous clauses. Considering all these factors and importance of cash flows, it is important that like DSRA Reserves are monitored by lenders, the cash/FDR margins for LC/BGs also needs to put in the centre of monitoring. It has to be a financial Lever and depending on the project intricacies, insertion of onerous clauses of waiver of mandatory clauses, project progress, extensions allowed, banks need to increase/build up the margin for such exposures.

Escrow Arrangements

In the past it has been seen that some borrowers diverted the advance payments received from one project to other projects in their difficult times. This results in affecting the progress of the various projects, dissatisfaction of the project authorities and invocation of BGs. In order to avoid such circumstances, it would be prudent to monitor the cash flows of the projects through Escrow A/c arrangements. This is specially required when there is a sub-contract arrangement. The standard formats of BGs stipulate effectiveness of BG only after receipt of advance payments in to account of the borrower with the BG issuing bank. Such compulsory clauses should not be relaxed.

Concurrent Auditor

RBI has made it compulsory forming consortium arrangements for borrowers availing more than Rs.100 crore (USD 15 mn) (SMA2 A/cs) of borrowings from banks. Many mid/large EPC companies are banking under consortium arrangement. The EPC companies being involved with many projects, it is essential for the consortium to have real understanding on the project cash flows of the borrower. Control on the cash flows is one of the most critical aspects in lending. I had written earlier about this in my article (Time to set New Normal : Adopting Cash Flow Based Monitoring). In all the restructured cases banks appoint Concurrent Auditor for monthly/quarterly reports on the cash flows, receivable position, intergroup/related party transaction etc. Considering the multiple project cash flows, it would be prudent that consortium adopts practice of appointing Concurrent Auditors in lending to EPC contractors. Such practice would help in understanding the project cash flows.

Needless to say, the Early Warning System (EWS) put in practice by banks in India is component of the overall monitoring framework and has to be followed for timely mitigation actions.

With the efforts of Government of India many contract opportunities are opening for the EPC/Construction sector and providing room for business growth to contractors as well as lenders. Prudent controlling and monitoring practices would not only support in constructive lending but also protect the interest of all the stakeholders in long term.   

Banking Efficiency (version 2016) – Uniform formats for Assessment

Banks in India follow practice of financing under Multiple Banking Arrangement (MBA) or under Consortium for Working Capital (WC) finance. Similar practice is followed for project/term loans on achievement of financial closures. Borrowers approach the lead bank in WC Consortium every year for assessment/renewal of WC limits. This process takes on an average 2-3 months time for a mid/large scale corporate borrower. After detailed appraisal/assessment, the lead bank shares its assessment note with the other member banks in the Consortium. The member banks use this note for renewal/enhancement assessment at their end. But when? If the note is received say in January, when will the member banks use it for assessment at their end? The answer is : in normal circumstances, they will use it only when the limits are due for renewal at their end, and if such due date is say in May, then it will be May only when the note will be used. Surprisingly the renewal exercise at each member bank, takes average 1-2 months time even after assessment by lead bank, and lead bank shares its assessment note! But why? The first reason being of course is that all member banks do not maintain a common date for renewal, which leads to information in lead bank note becoming obsolete or requires updation by the time limits are due for renewal at their end. The second issue is that all banks individually also undertake the same full assessment exercise i.e. management study, analysis of financials, ratios, industry/market research, limits assessment, risk, mitigants, KYC etc, however in different formats. Each bank has its own devised formats which more or less contain similar information. But since the formats are not uniform and there is no written unanimous guideline for computation of ratios etc., each bank takes the support of lead bank note and prepares it own assessment/appraisal note.

In case of term loans the appraisal note is shared by bank if borrower pays a huge appraisal fee for such sharing. As mentioned above, even if it shared, it is of limited use in terms of efficiency in swiftly completing the assessment by other banks due to the issue of different formats prevailing in each bank. This applies even to the Syndicated/Underwritten deals, where the Information Memorandums (IMs) are of limited use as long as efficiency is concerned.

Think of the enormous time, energy, resources, systems, people, etc. invested by each bank in undertaking the same exercise which is already done by leader of the consortium, and even shared the assessment/appraisal note. Whether this meets the efficiency levels we expect in this challenging business environment?

In a time when Government is focusing on improving the system efficiencies in financial sector, formed the Banks Board Bureau (BBB) for improving the working of public sector banks, is it not time to address this issue of not having uniform formats in banks? If this is rectified, imagine how faster it would be to achieve financial closures for the WC/project finance. The Corporates will be able to use the saved time and resources in addressing the other issues. Banks will be also able to save their huge time which they can devote for processing additional proposals. Hence, addressing this small issue can hugely benefit India Incorporation, and its indirect effect would support the overall productivity in economy which is struggling to keep growth rate high.    

The above issue can be easily addressed by IBA/RBI by initiating dialogues with banks in drafting the uniform formats, uniform definitions of ratios, covers etc. for WC and project assessment. They can also initially conduct workshops for adopting the uniform formats. There could be need for addressing sector specific formats which can be also facilitated. There can be some information like industry exposures etc. specific to each bank which cannot be covered by lead bank in its uniform assessment note. Such limited information and the commercials pricing etc. can be prepared and topped up by each bank over the lead bank’s uniform assessment.

As a long term solution and efficiency building exercise, they can facilitate software which can generate industry specific templates having required assessment fields and formulas. This will standardize the assessment practices in banks without tempering with the templates/formulas. They can keep on improving/developing this software in consultation with banks over time.

There is thrust by RBI that each bank should undertake its own due diligence for exposures taken. To this effect, lead bank can share copies of supporting back up papers to enable the other members individually verify critical data.

Banks will be able to address the other issue i.e. of not having common due dates for renewals, once the uniform formats are adopted. Since the uniform formats will significantly reduce the assessment time, member banks will be also able to immediately take up the assessment exercise.  

Time to set New Normal : Adopting Cash Flow Based Monitoring

The rising NPAs have given sleepless nights to the bankers. The gross NPAs of Indian banks increased from Rs.83,000 crore (USD 13 billion) in FY 2010 to Rs.3,23,000 crore (USD 48 billion) in FY 2015, and this figure increased to Rs.5,72,000 crore (USD 86 billion) at the end of Q3 FY 2016. In many of the cases diversion of funds is reported to be one of the key areas of ongoing investigations. The existing banking system is based more on sharing of data among the lenders for their common borrowers. The bankers exchange of information of borrowers on regular basis. Generally such sharing is frequently and timely when account has already turned NPA or almost reached to become an NPA !!

Dilemma of Existing Mechanism for Sharing Cash Flows

In a Working Capital arrangement of bankers, every lender requires the borrower to route its business transactions through it on proportionate basis (i.e. based on percentage share of the lender in total Working Capital Borrowing tie up). The purpose is of three folds, one it gives them some hands on experience in understanding the business transactions of the borrower, two it helps in understanding the real volume of business, and three it gives access to interest free cash flow / deposits which has probability of remaining with lender for some time. It is very common that lenders complaint / pursue the borrower for routing cash flows. Lenders generally do not come together by relying on one of the lending members for first taking all the cash flows and then passing on the proportionate share to other lenders. Of course, this is commonly done when account becomes non performing (i.e agreeing to sharing cash flow when cash flows have already dried up!!), restructured and Trust and Retention Account (TRA) is managed by lender having largest share. Projects with concession agreements (i.e. like BOT Toll Road projects or City Water Supply projects etc.) are some of the exceptions to the situation where TRA takes place by virtue of the concession agreement. 

The Big Problem

Unscrupulous borrowers take the advantage of weakness of the system. Such borrowers maintain accounts with multiple banks, route cash flow to various A/cs in the absence of any fixed set of rules and enjoy ease of diverting the funds by complex chain of transactions. Such liberty of disproportionate cash flow routing or routing to banks not part of lending consortium/ arrangement is enjoyed by the borrower on the name of all lenders pursuing for larger share of cash flows. The lender getting larger share in cash flows remains cheerful and does not complain about such indiscipline of the borrower.

Such borrowers also ensure maximum squeezing of undrawn loans/working capital lines before they disclose their deteriorated financial position to the banks.

TRA Arrangement

In today’s highly technology driven world, it is important and possible to have dynamic understanding/control of the income and major expenses of the borrower. A Trust and Retention Account (TRA) Agreement is a documented arrangement wherein rules are framed to channelize the cash flows of a borrower in a systematic manner. The agreement provides the Water-fall mechanism in which the cash inflows will be utilized. The Water-fall mechanism provides the details of various key accounts to be maintained by the borrower, like Income A/c, Critical Expense A/c, Statutory Dues A/c, Tax A/c, Debt Service Reserve A/c (DSRA), Interest Expenses A/c, Principal Payment A/c etc. and their priority order for channelling the cash flow. Generally TRA is stipulated in restructured loans while in other cases Escrow A/c is stipulated. TRA is strict mechanism of cash flow management to be maintained by the borrower. In comparison to TRA, Escrow can be considered a bit lenient mechanism which makes sure that all the cash inflows are brought into one account and transferred by the Escrow bank as per the Escrow agreement. Sometimes Escrow is followed by Supplementary Escrow Agreement stipulating the TRA Water-fall mechanism. All these arrangements of TRA / Escrow are well developed by the banking sector, and lenders are well equipped in managing TRA/Escrow.

Adopting the Technology

The point here is that with the advancement of technology and app driven convenience, these mechanisms can be further made efficient with technology support. For monitoring purpose, lenders now need to change their first focus from analysing the financial statements to hands on control on the cash flows of borrower. This needs to be adopted as a practice. Ultimately, it is the cash which matters and if cash is monitored well, rest of the things would fall in line. The need of hour is that it is not only the borrower getting SMS on his phone when his account is debited but also the lender should come to know about the utilization and details. Hence, time demands for setting standards, rule of game and as matter of basic practice & principal to adopt the cash flow focused monitoring.

It has been experienced that in restructured cases TRA arrangements, the TRA bank/agent is often accused of using the cash flows for recovery of its own overdues. The solution could be resolved by appointing any bank as TRA agent having no exposure to the borrower.  Adoptions of such practice by the banking industry would set it as market standard. As usual, adopting any new practice is faced with initial hiccups. With the adoption of TRAs at industry level, the increased business volumes and competition would bring down the TRA bank fee. Allowing benefit of retaining /maintaining some balance with the TRA agent could drastically reduce the fee for implementing TRA. Over the time borrowers will also get accustomed to managing the TRA and it will become a new normal in practice.  

The segregation of income into a separate account and routing all the sales to one single account as per TRA arrangement, would help in understanding the actual sales volume regardless of accrual accounting based income as per financial statements. Segregation of expenses and tracking of related party transactions would help in controlling diversion of funds.

The transaction monitoring can be filtered to reduce SMS volume on the phone of banker by setting  minimum transaction size, frequency, tracking related party transactions and type cap for such reporting to the banker. Instead of getting SMS alert for all the transactions, the banker may get alert only when some alert is triggered like the cheque issued by the borrower is returned/dishonoured, or when limits utilization are reaching some peak level (say 80%) or when the interest/principal is not paid on due date, etc. Depending on the category/rating of the borrower, status of the account, such triggers can be increased/reduced. Such type of filtering would hugely reduce the volume without defeating the purpose of monitoring. They app driven technology may also facilitate easy management of such triggers.

The Reserve Bank of India has already issued guidelines on Early Warning Signals (EWS) and facilitated CRILC database check, which would supplement the Cash Flow based monitoring. The use of advance predictive and prescriptive analytics can further create significant impact in monitoring the accounts.

It is not easy to identify customers before they default, however, with the advancement in technology, monitoring of cash flows can be managed in an efficient, improved and controlled way which would support in identifying the problem accounts before the damage happens.

External Credit Ratings: Time to Change the Process and the Gold Standard of Rating

The Union Budget has proposed a new credit rating process for infrastructure projects. This is expected to support fund raising on reasonable terms for such projects. At this juncture of Economy when need for such a different rating system has been envisaged, then it would be also of importance to review the traditional process of external rating system.

The credit rating agencies are meant to provide lenders with an informed analysis of the risk associated with debt instruments. These ratings are usually characterized by a letter grade, the highest and safest being AAA, with lower grades moving to double and then single letters (AA or A) and down the alphabet from there. The ratings approved by these agencies have widespread implications for lenders.

Lot has been said about the failing of credit rating’s efficiencies in warning the defaults since year 2008. The big three global rating agencies had come under intense scrutiny in the wake of the global financial crisis. These agencies in year 2008 were accused of offering overly favourable valuations of insolvent financial institutions and approving risky mortgage related securities.

The Fee Model of Rating Industry: Subscribers Pays or Issuer Pays

Most of the credit rating agencies follow the Issuer Pay model wherein the borrower who is getting its debt rated pays to the rating agency. Therefore, the borrowers who need certain ratings in order to sell their debt to lenders may have been willing to pay more for their preferred rating. It is noted that under Issuer Pay model the borrowers shop with the credit rating agencies for the desired/lenient rating band. The competition among the rating agencies at one hand benefits the borrowers but on the other hand affects the interest of lenders. It is evident in the market that many borrowers, who are rated below investment grade shop with the rating agencies, change their rating agency and are able to get investment grade ratings if not very high but at least at lower end of the scale. This helps such unscrupulous borrowers in passing the muster of lenders for getting loans sanctioned.  Lenders carry out their own internal credit rating of the loans. The external rating presents an external independent view. However, if the external view is investment grade, it may create some positive impressions over the internal ratings also.

Its time to take control of the Wheel

For long time, the process of credit rating has been allowed to be handled by borrowers. When the Budget envisages need for different rating system for infra projects then there are enough good reasons for relooking at the rules for existing rating process also. Excluding the rating process, many other exhaustive monitoring related activities like Stock Audit, Concurrent Audit, Lenders Independent Engineer, Valuations etc. are controlled and efficiently, cost effectively managed by lenders. From that sense isn't the time ripe to control the external ratings process of the loans also?

Like controlling the exercises (which are lengthy and complex) of Stock Audits and Concurrent Audits, lenders can also control/handle the External Rating process of the loans. This would provide better information to rating agencies (since the existing informal channel of interactions between the two will turn into a formal one to one dialogue as it happens in Stock and Concurrent Audits), facilitate information, and the open interaction between two would help in deeper understanding the critical issues.

There are pros and cons of everything. External credit rating has great importance since it is expected to present an unbiased view on probability of default. Their independence can not be compromised and allowed to be influenced by bigger forces (banks/FI etc.) in the financial market. I agree that the above suggestion also has some chances of influencing the freedom of credit rating agencies decisions as they would need to deal with much bigger and powerful set of customers (lenders/banks) who could then threat diverting business to the competitors following lenders views.

Benefit in Interest Rates/Subsidies

A balancing solutions would be to have credit ratings from two agencies, one obtained directly by the borrower and other done through the lender. This could be adopted for loans of Rs.500 million and above. In case of large difference between the two, decision makers will have enough warning signals for analysing the matter before taking their call. For loans between Rs.100 million to below Rs.500 million government may come out with schemes for subsiding the cost of second credit rating. National Small Industries Corporation (NSIC) provides reimbursement of credit rating fees to the small scale industries (http://www.nsic.co.in/creditrating.asp ). However, the option of two external ratings would further increase the cost of borrowing and involve extra time & energy. To reward for the pain taken by the borrower and reducing the cost, lenders may benefit borrowers going for two ratings system by providing some concessions in interest rates/processing charges.

Regulatory Compulsion for Rating

One of the other effective solutions could be putting restriction on changing the credit rating agency within a period of 3 years from their appointment and making the external rating compulsory for loans of above Rs.100 million before availing sanction of loans from lenders. The borrowers who do not get their rating re-validated timely or are not keeping their rating live may be compulsory penalized by increase in applicable interest rates. Regulatory framework may be developed in this regard.

The Gold Standard of Rating

The rating agencies community also need to come out with a standardized product of Gold Standard Rating supported by necessary changes in regulations, where the common high standards of uncompromised rules and procedures may be defined. The borrowers may be encouraged to go for such high standard Gold Ratings. The reward for such ratings would come in the form of high investors/lenders interest with premium pricing. Adoption of these high standards may be made more attractive by allowing certain low ticket Gold Standard rated loans eligible for Priority Sector Lending (PSL) (https://en.wikipedia.org/wiki/Priority_sector_lending). The Gold Standard rating would reflect the rigorous due diligence passed by the borrower and reflects its high standards on accounting & audits, cash flow management & monitoring, corporate governance, professionalism of management like aspects. The rating agencies could be heavily penalized for comprising any rule under such Gold Standards.   

Time to Re-write Rules of BGs?

Over the years banks have been in business of guarantees which generated handsome commissions. However, past few years of downturn have given lessons with sleepless nights to issuers. The beautiful business turned into ghost. During the growth period few years back mostly in infrastructure/EPC long period guarantees (Performance/Mobilzation/Advance) were issued in general however what could not be noticed was the insertion of onerous clauses or deletion/compromise of standard clauses. This along with unconditional nature of the guarantees gave upper hand to the beneficiaries and allowed freedom to the borrower in diversion of funds. Many standard clauses in BGs such as auto reduction in BG with performance of contract or effectiveness of BG only on crediting the advance payments to the contractors account with the BG issuance bank could have helped. It’s not that bankers had not objected to such deviations however going by the experience I can say that to some extent it was stubborn nature of the beneficiaries taking the benefit of cut throat competition in banking. But does it not mean that regulators need to control competition or three regulator/appex association of banking  need to define standard clauses which can not be comprised ? Further, any large BG is as good as a loan and requires the equal due diligence and monitoring. Lessons already learnt.