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NPAs of banks have reached alarming levels and this is not just because of a slowdown. The first of a four part series
Until the first major oil shock of 1973, banks were probably not exposed to such a wide variety of risks that had not been widely experienced until then. These were: Rapid changes in interest rate; capital and foreign market gyrations; risk arising from cross border lending; operational risks including those relating to narcotics; and underworld transactions, risk posed by break down of interbank payment system so on. Meanwhile, credit risk—or the chance that a borrower may default on loan obligation— retained its primacy in the hierarchy of all risks, since lending continues to be the primary function of banks.
Credit dispensation by banks brings together savers and investors of a community and bridges the time gap between the entrepreneur’s intention to start an economic activity and to raise the resources needed for it. What is often not explicitly understood is that each party in this transaction runs a risk, albeit of different nature: Savers may lose money if the banks fail; banks collapse if their borrowers default in large numbers, and borrowers may sink if the economic activity for which they borrowed fails. Unfortunately, such failures have wider ramifications for the economy as a whole.
Lending is a function that requires evaluation of an amalgam of factors like the history, competence and character of the borrower, security offered against the loan, nature of economic activity and pricing of the loan. Above all, it requires a clear appraisal of the future of the activity in terms of cash flow and profitability, to name only two. Management guru, Peter Drucker said, “Economic activity, because it is activity, focuses on future and the one thing that is certain about future is its uncertainty, its risk. Profit is the premium for the risk of uncertainty”. Thus even when a credit proposal to finance an economic activity is considered ‘perfect’ as of now, there is no guarantee that the loan remains within the risk assessment made at the time of origination.
There are many ways in which the dimensions of credit risk are sought to be minimized. These consist of factors mentioned above together with the stipulation of special covenants and an effective system of follow up of the borrower’s operations, etc. Whatever may be the rigour of credit appraisal and follow up and monitoring of loans, some loans sour up for a number of reasons, not necessarily of dishonesty or incompetence of the borrower. External factors outside the control of borrowers, like say, power cuts, as is being experienced by many enterprises across the country now, could result in non-adherence to the terms of the loans, repayment obligations, etc. These will eventually add up to the statistics of non-performing assets (NPAs) of the banks but behind each NPA, there could be a story of socio-economic and moral malaise.
By evaluation of the circumstances of each case of stress experienced in the conduct of loan accounts, banks are required to make, unavoidably with some degree of subjectivity and perception, dilemmatic decisions of “to or not to” assist the borrowers by way of holding operations, restructuring of loans, seeking merger with a stronger enterprise, granting of additional loans, etc, to nurse them back in the expectation of regaining viability, or cut losses by treating the operations as unviable and mark the loan for recovery. These decisions call for wisdom, earthly common sense and may be some luck, as well. They could prove wrong in course of time, which is the price of doing business. In any event banks start making prudential provisions if the loans turn into non-standard category; in recent years, general provision is made on standard assets as well as a further buffer.
No bank can be true to its basic economic function if it were to hesitate to take difficult decision because it could have an immediate adverse impact on its financials and on the career of the person(s) making the decision. When a decision to assist the borrower’s operation proves wrong, there are a whole lot of authorities including vigilance officers, with inadequate knowledge and field experience, infested with hindsight to adjudge and attribute motives to the officials who made the decision, generating in the process bank-wide fear complex and hesitancy in making decisions. As the former chairman of the US Federal Reserve, Alan Greenspan said in the US context, “A perfectly safe bank, holding a portfolio of treasury bills, is not doing the economy or its shareholders any good”. If the banks in India were to invest the customer deposits in government securities—a system called narrow banking—they could be safe; but the government is not the only agency in economic function of the country nor is it most efficient. Such an appropriation by the government of resources garnered by banks can undermine the democratic system itself.
The growth of NPAs in Indian banks has been a matter of serious concern. This is not in the least due to failure of economic activity in the normal course of business, or dishonesty of the borrowers or due to bad decisions/to indifferent follow up/even occasionally reported acts of malfeasance on the part of bank officials. On a larger canvas, rapid rise in NPAs reflects also on decadent values of the society heavily influenced by the socio-political developments. The loan ‘melas’ of the late 1980s, periodical debt waiver schemes, promise of free power, etc, on the one hand; and rampant corruption, generation of black money and periodical announcement of voluntary disclosure schemes for tax evaded income, etc, on the other hand have all taken toll of the cherished values of the Indian society, and in the process scalped the Rule of Law.
The Narasimham Committee II (1998) explains succinctly the economic consequences of NPAs as, “NPAs constitute a real economic cost to the nation in that they reflect the application of scarce capital and credit funds to unproductive uses. To the extent that banks seek to make provisions for NPAs or write them off, it is a charge on their profits. To be able to do so, banks have to charge their productive and diligent customers a higher rate of interest. It thus becomes a tax on efficiency. NPAs, in short, are not just a problem of the banks. They are bad for the economy” (Emphasis added).
Let us now turn to the magnitude of the NPAs. As of March 2011, all scheduled commercial banks reported gross NPAs at Rs97,922 crore, net NPAs (after setting off provisions) at Rs41,813 crore, accounting for 2.25% and 1.11% of the gross advances. Of the gross NPAs, priority sector loans for the year (directed lending) accounted for 51.8%. These banks made aggregate provisions of Rs38,742 crore from out of their earnings. The Reserve Bank of India (RBI) has estimated that the NPAs could indeed go up substantially if the loans restructured in 2009, as per its onetime special dispensation to meet the problems arising from global the financial meltdown, were to become non-standard. The total loans restructured amounted to Rs1,06,859 crore. (figures quoted in this paragraph are taken from the RBI’s Report on Trend and Progress of Banking In India 2010-11). Plausibly the NPAs reported as of 2011 may turn out to be understated.
How do banks, nay, indeed the RBI and the government tackle the menace of the growing NPAs in banks?
(A Banker is the pseudonym for a very senior banker who retired at the highest level in the profession.)