NPAs in the Indian Banking Sector
Non-performing assets or NPAs have been an ongoing problem in the Indian banking sector for the past few years. So much so, that finance minister Nirmala Sitharaman?submitted a blueprint for setting up the National Asset Reconstruction Company Limited (NARCL)?during budget 2021 with the aim of cleaning up bad loans in the public banking sector. NARCL was approved by the cabinet in October 2021.
The Indian banking system consists of 12 public sector banks, 22 private sector banks, 44 foreign banks, 43 regional rural banks, 1,484 urban cooperative banks and 96,000 rural cooperative banks (Indian Banking Industry report, 2021)
India has one of the highest banking NPA ratios in the world. Macro stress tests indicate that the gross non-performing asset (GNPA) ratio of banks may increase from 7.48 per cent in March 2021 to 9.80 per cent by March 2022 under the baseline scenario and public sector banks' (PSBs') GNPA ratio of 9.54 per cent in March 2021 may edge up to 12.52 per cent by March 2022. For reference, major economies in the world like US, Britain and Australia have NPAs at approximately 2%. [1]
According to Demirguc-Kunt and Detragiache (1998), a crisis episode takes place when at least one of the following conditions is met: The ratio of NPA (non-performing assets relative to total assets) exceeds 10% in the banking system or banking sector problems cause nationalization of banks on a large scale and cost of the rescue operation is at least 2% of GDP. While the RBI has been in crisis mitigation mode for a few years now, it is important to examine the factors that lead to NPAs in the first place. We could already see some premature effects from GDP growth decline. If the % GDP growth for 2017 at 6.681, lower than GDP growth for 2016 at 7.113 (World Bank, 2018) seemed alarming to many people, the -8% growth for 2020 seems like a catastrophe to say the least. However, the negative GDP growth rate is a direct consequence of the pandemic and most countries experienced a steep decline in their GDP growth.
Relative causes of NPA occurrence cited by some researchers include; economic condition, interest rate, inflation, credit growth, inefficiency, profitability, bank size and ownership, and credit culture. Given the common understanding of factors that lead to NPAs, it is important to evaluate the factors that lead to non-performing loans by looking at two of the most important factors - macroeconomic and firm or bank level indicators. This kind of understanding is imperative for finding the right solutions to solve the NPA problem.
The macro-economic factors include; real GDP growth, inflation growth, and average prime lending rate prevailing in the economy. The bank-specific factors include loan growth, bank size and bank efficiency.
Indian banking sector and NPAs
Indian banking sector as a percentage of total asset of the financial system. India’s retail credit market is the fourth largest in the emerging countries. It increased to US$ 281 billion on December 2017 from US$ 181 billion on December 2014 and is current.
Between 2017 and 2020, as India’s consumer credit markets grew by 18% to $613 billion,1?we noticed several noteworthy trends emerge both in search and demand. In the second half of 2020
Fig 1: NPA ratio 2009-2021
** RBI estimate, *RBI estimate
Fig 2: Gross NPA in Rupees
Performance of the Indian Banking sector vis-à-vis the performance of neighboring economies needs to be examined closely to look for factors indicating possible decline. Indian Banking sector is in ‘secular decline’ although NPAs declined for a few years before increasing
?The NPA crisis is more widespread in the public sector compared to the private sector. Even though NPAs declined in the last two quarters of 2018, NPAs are at 14.12% of loans and advances for public sector banks and 10.58 % of loans and advances for private sector banks
Macroeconomic and Banking Determinants
Two sets of factors explain the evolution of NPAs over time.
Theoretical background of the study by Diamond (1984) on delegated monitoring theory of financial intermediation offers key insights. Under this theory, depositors delegate monitoring of their funds to banks. Risk increase when banks make adverse loan selection. Therefore, inefficient monitoring by banking institutions explain reasons for high loan defaults.
Significant and positive relationship between problem loans and GDP decline. Macroeconomic factors are viewed as exogenous forces which are influencing bank’s performance.
Average prime lending interest rates are positive and significantly related to NPAs in commercial banks. The relationship between inflation and NPAs is also positive and significant.
?Within bank specific determinants, there is a strong relationship between credit growth and impaired assets. Poor management in banks can imply weak monitoring for both operating costs and credit quality of customers, which will induce high levels of capital losses resulting in higher NPAs. These bank specific determinants make sense because banks that have a higher profit margin tend to have lower NPA ratios. Therefore, it is important that bank become more cautious when they seek to increase their loan book and make sure that the best management practices are followed. We have also seen that it is usually the larger banks that have a higher NPA ratio – implying that bank size has a positive effect on NPAs.
In conclusion, NPAs have become a nagging problem in the Indian banking system with the public sector banks showing higher NPA ratios compared to private sector banks. In order to better understand and solve for this problem, it is important to closely study the factors that positively contribute to NPAs (which means they make the NPA problem worse) and then effective problem solve around the key factors. The RBI has implemented some great measures that brought down the NPA ratios in the 2017-2019 period. However, new measures and policies are needed given the onslaught of the pandemic, especially pose the second wave period.
[1] India has a financial crisis and how to solve it (Financial News, 2019)