NPAs: Building blocks of crisis

What is an NPA?

Conceptually speaking, a credit facility becomes an NPA when it ceases to generate income for the bank. NPAs can be sub-standard if pending for 12 months, doubtful if above 12 months and lost if it is long-drawn with little hope of recovery. A loss of asset is one where loss has been identified by the bank, an internal or external auditor, or during an RBI inspection.

As per RBI rules, out of every Rs 100 deposited in a bank, Rs 4 is parked with the RBI and Rs 19.5 in assets like bonds or gold. Almost a quarter of the money in the system can be retrieved in case of a contingency while the bank is free to lend the remaining Rs 76.5 to borrowers. The interest gleaned on such loans is used to compensate the bank's customers as interest payment and the remainder is the bank's profit. NPAs arise when banks lend to clients who default on their repayment, making the bank sick gradually. RBI's Financial Stability Report, 2017, states that India's gross NPA stands at 9.6 per cent, though Care Ratings finds NPAs at 11 per cent of the total lending by public sector banks (PSBs). India has the second-highest ratio of NPAs among the major economies of the world. Only Italy, with 16.4 per cent NPAs has more stressed assets. China, whose economic growth is largely fuelled by borrowings, has only 1.7 per cent NPAs, according to the IMF. According to former RBI Governor Raghuram Rajan, broad estimates show that Indian banks are currently burdened with bad loans that amount to more than Rs 9 lakh crore.

Why do NPAs happen?

NPAs occur due to several reasons, for instance when the borrowers diversify funds to unrelated businesses or engage in frauds. There can also be lapses by the bank. Often, there are business losses due to changes in regulation.

Then, there are cases of global, regional or national financial crisis, eroding margins and profits of companies, therefore, stressing their balance sheet which finally results in non-servicing of interest and loan payments (eg: 2008 global financial crisis). The general slowdown of the entire economy is another reason. For example, after 2011, there was a period of slowdown in the Indian economy which resulted in the faster growth of NPAs. There can also be a slowdown in a specific industrial segment, therefore, companies in that area bear the heat and some may become NPAs.

Unplanned expansion of corporate houses and loan taken at low rates later being serviced at high rates, therefore, also result in NPAs. NPAs can also be due to maladministration by corporate houses, for example, wilful defaulters. Misgovernance and policy paralysis in borrowing houses hamper the timeline and speed of projects, therefore, loans become NPAs. Delay in land acquisition due to social, political, cultural and environmental reasons can also lead to NPAs. There are cases of bad lending practices in the case of Kingfisher and Nirav

Modi – involving non-transparent ways of giving loans.

The current Indian government had no hesitation in writing off Rs 2.41 lakh crore in the last three years and gross NPA stands at Rs 9 lakh crore today, which was around Rs 3 lakh crore in 2014. Sanjay Das, Secretary, All India Bank Officers Confederation (AIBOC), West Bengal, notes that for the last four years, PSBs have been earning gross operating annual profits ranging from Rs 1.3 lakh crores to Rs 1.6 lakh crores – but net profit is wiped out due to the bad loans, given through political decisions.

Faces behind accumulation

First, there is a nexus between manipulative borrowers and public sector bank officials, often with political blessings, who rip off public sector banks, best witnessed recently at the Punjab National Bank (PNB), Fort Branch, Mumbai, fraud where diamond merchant Nirav Modi allegedly colluded with branch officials for several years to hoodwink the bank. Second, there are farm loans, whose waivers irk copybook economists but are mercifully not being discussed much this year, partly because general elections are close by and mostly because farmers pale in comparison to the fat cat borrowers. Former Governor Rajan's recent note to the parliamentary committee on bad loans makes the fraudulence of corporate borrowers abundantly clear.

It is important to note that the Corporate Industry Loans (73 per cent of all NPAs) are sanctioned by government-appointed Board Level Executives to big industries. Agriculture NPAs (9 per cent) are mostly due to unthought Farm Loan Waiver policies. Services NPAs (13 per cent) is mostly like MUDRA loan, where the current central government bars banks from taking collateral and, hence, banks cannot recover and the borrowers happily default. Retail NPA, accounting for less than 4 per cent, is the only NPA where a common branch-level banker makes a sanction.

Shadow of NPAs

The RBI's Financial Stability Report names the basic metals and cement industries as the most indebted. Despite the recent GDP numbers which point to lukewarm growth, the metals industry continues to be hamstrung by slow demand and cheaper imports. The construction, infrastructure and automobile industries also account for a sizeable chunk of banks' NPAs.

Data collected by the Ministry of Statistics and Programme Implementation (MOSPI) and compiled by the World Bank reveals that economic growth tapers off with a spike in the bad loan ratio. While economic output has been laggard over the past few quarters owing to disruptive policies, the lacklustre performance of India Inc has pulled down banks with greater defaults from corporate clients. The gross NPA ratio has spiked from 5.9 per cent in 2015 to 9.6 per cent in 2017 while economic growth has slumped in the corresponding period.

Stress in the banking sector makes less money available for other projects, impacting negatively on the larger national economy. Higher interest rates are imposed by banks to maintain the profit margin. There can be redirecting funds from the good projects to the bad ones. As investments are stuck, it may result in unemployment. In the case of public sector banks, bad health means a bad return for a shareholder, implying less money for the government as dividend.

Tackling NPAs

The framework for Mission Indradhanush, 2015, created for transforming PSBs, represents the most comprehensive reform effort undertaken since the 1970s banking nationalisation to revamp PSBs and improve their overall performance.

Insolvency and Bankruptcy Code Act, 2016 has been formulated to tackle the Chakravyuh Challenge of the exit problem in India. The aim of this law is to promote entrepreneurship, availability of credit and balance the interests of all stakeholders by consolidating and amending the laws relating to reorganisation and insolvency resolution of corporate persons, partnership firms and individuals.

Bad Banks, 2017: Economic Survey 2016-17, also talks about the formation of a bad bank which will take all the stressed loans and tackle it according to a flexible mechanism. It will ease the balance sheet of PSBs, giving them the space to fund new projects and continue the funding of development projects. It has not been put into practice yet.

Innovation & challenges

The need of the hour in tackling NPAs is formulating an urgent remedy. This should include technology and data analytics to identify early warning signals, a detailed mechanism to identify the hidden NPAs, development of internal skills for credit assessment within the banking system and forensic audits to understand the intent of the borrower.

Raghuram Rajan gave us the term 'non-cooperative defaulter' to describe the corporate bigwigs who can't or won't pay back the loans they took. Arvind Subramanian speaks now of 'stigmatized capitalism' that stops the government from adopting reformist solutions. All diagnosis, no cure. Unless you find some merit in Subramanian's preference for a 'judicial solution' to the pile of unpaid loans in listed banks.

Today, without a framework for bankruptcy and orderly resolution, India faces the risk that if a large private sector bank goes bankrupt, there is no legal way of dealing with it other than to force a public sector bank or an insurance company like the LIC to buy it out. To serve the growing needs of the economy for debt, equity, payment systems and innovations in financial products and services, it is imperative that regulatory reform is undertaken at a much greater speed.

A corporate bond market is an ideal solution for freeing banks and businesses from this eternal cycle of bank loans and NPAs. The idea remains still-born despite numerous committees recommending it. The fortunes of the market are currently hostage to an inter-regulator turf battle. There are no easy solutions for NPAs; at least not till April 2019.