The latest RBI Financial Stability Report, released on Wednesday, paints a picture of a relatively sound Indian financial system, whose major challenge is now from outside. This is also true to a large extent. But it’s hard not to worry that this feature is a bit too comfortable, given that it has recently been a period of sluggish economic activity, regulatory adjustments to banking stress (through moratoriums on loan payments during the pandemic), and banks needing avoid). mark to market a large portion of its bond holdings), slow disbursal of loans, and aggressively writing off bad debt and making provisions against bad loans.
Have the systemic and regulatory deficits that trigger the periodic ballooning of bad loans been addressed? Have new institutional practices been adopted to ensure better regulation and supervision? Now that credit growth is picking up pace, can we assume that the twin balance-sheet crisis – involving banks and the companies that have borrowed from them – will not resurface? The answer is not quite an emphatic ‘yes’.
The Financial Stability Report itself shows that bad loans – non-performing assets or NPAs in jargon – tend to rise and fall from time to time. The total amount of loans not repaid for three months forms the gross NPA. What banks lend is the savings of depositors, and a bank cannot afford not to pay depositors even if a borrower does not pay. So it starts setting aside funds to cover the risk of non-recovery from borrowers. This is called provisioning. The higher the provisioning, the lower the risk to the depositors. Gross NPA less provisioning is net NPA. The provision comes from the bank’s income and is included in the profits. On the other hand, if a bad loan for which a provision was made is later repaid, the money set aside can be written back into the bank’s income and go directly to the bottomline.
GNPA as a proportion of total assets was 11% in 2002, fell to 2.5% by 2010, climbed back to 4.1% by 2014, increased to 11.5% by 2018, and fell back to 3.9% by 2023. At a stage when banks are handing out loans, the ratio of NPAs to total loan disbursements may fall if total loan disbursements grow faster than the total quantum of bad loans. This liberal expansion of credit may increase the burden of bad loans in subsequent periods. Similarly, if banks are reluctant to lend for a period and some loans turn bad, this may lead to an improvement in the NPA situation in future.
Why do banks freeze bad loans? The underlying viability of the activity for which the loan is taken is a factor. The bank’s ability to determine such viability is another. The malfeasance that can lead bankers to be overconfident about a project’s viability is another. The defrauding of Punjab National Bank by diamond merchant Nirav Modi involved the collusion of the bank’s employees, who bypassed the core banking system while directing foreign banks to grant loans to the trader.
When the IL&FS crisis broke out, it was discovered that at least six banking and non-banking financial institutions were giving circular loans – a loan from which money was withdrawn and was being repaid with a larger loan from another lender. was, and so on. This escalating cycle of borrowing, with continuous withdrawals but no defaults, continued for some time.
Auditors who look at individual bank books may not always be able to catch this type of fraud. But there can be concurrent audit and analysis of interrelated financial flows. The consent layer of digital financial infrastructure enabled by Aadhaar and India Stack collection of APIs now lets borrowers consolidate all their financial activities and present it to a potential lender. This is achieved through the Account Aggregator Framework. Why not use this capability for concurrent audit of borrowers, with data filtered through sophisticated algorithms to understand interrelationships in real time?
Another reason for bad loans is that banks have to finance long-term projects, creating an asset-liability mismatch. A project may get delayed and capital infusion may be required, but the bank may not be in a position to make that adjustment. This triggers a default and from there the bad loan situation gets worse. The solution is to have a vibrant market for corporate debt in India, which infrastructure developers can access for their long-term projects, either directly or through infrastructure-finance companies.
Public sector bankers are governed by staffing norms and pay structures that do not align earnings with performance, especially at the senior level, while paying more at the junior level. As a result, staffing cost is higher in public sector banks as compared to private sector banks. This creates a strong desire to avoid risk. There is also a difference in the way regulators deal with private and public sector banks. Ideally, the quality of supervision and regulation should make the nature of ownership of banks irrelevant. Since this ideal is a distant abstraction, privatization will help.
All these factors, which underpin the performance of the banking system, have not been taken into account. Gross NPAs have come down, large provisioning has reduced net NPAs to negligible levels, capital to risk-weighted assets and Tier-1 equity ratios are high, and some other indicators also look healthy, but this does not mean that Not that Indian banking has suddenly become healthy.
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Updated: June 30, 2023, 12:57 PM IST