The large and increasing levels of non-performing assets (NPAs) of the Indian banking industry, especially of the public sector banks (PSBs), has been dominating headlines for quite some time now and there seems to be no end to this saga.
Gross NPA to total assets ratio (GNPA ratio), one of the key tools of measuring NPA levels of the Indian banking industry (i.e., their efficiency), stood at about 8.5% at the end of March 2020 (11.3% for PSBs and 4.2% for private banks), and is expected to increase to a level of around 14% by March 2021.
To put these NPA levels in perspective, we need to appreciate that any bank, with a GNPA ratio of, say, over 3%-4%, is essentially making operating losses. Incidences of bad loans are essential to the trial and error process required for development and are normal in dynamic financial markets, i.e., some amount of occurrence of NPAs is natural and expected in the banking business. However, the margin of error that banks can tolerate is very low.
As JD Von Pischke has very succinctly put, "Experience has shown that bad loans amounting to 3% of loan portfolios can give commercial banks and their government regulators major cause for indigestion."
The situation with which we are blissfully living is that some of our public sector banks (PSBs) have NPA levels of over 20%. With abysmal recovery rates most of these NPAs would have to be written off against capital. Therefore, banks with such high NPA levels would effectively have negative networth if the promoter, the government of India, had not infused fresh capital at regular intervals (Rs4 lakh crore over the past 10 years).
This is being funded by the poor Indian taxpayer who, in return, gets indifferent service, negative real interest rates on deposits, higher levels of interest rates on loans and lower levels of economic growth compared to the potential.
To manage and contain the NPA problem, academicians, policy-makers, the Reserve Bank of India (RBI) and the government have come up with a virtual alphabet soup of schemes over the past 40 years. This includes, Sick Industrial Companies Act (SICA), the board for industrial and financial reconstruction (BIFR), the securitisation and reconstruction of financial assets and enforcement of security interest (SARFAESI), debts recovery tribunals (DRTs), corporate debt restructuring (CDR), strategic debt restructuring (SDR), 5/25 mechanism, joint lenders' forum (JLF), scheme for sustainable structuring of stressed assets (S4A)—to name some, the Insolvency & Bankruptcy Code (IBC) being the latest 'magic wand' to address this gargantuan problem.
The moot point is that all of them aim at resolving NPAs and not one of them is designed to ensure that the incidences of NPAs are controlled.
One of the key functions of banks is to continuously produce good quality loans & advances or loans, which have a low probability of default. From this perspective, the incidence of high and growing levels of NPAs in the Indian banking system is akin to a manufacturing organisation making a larger than acceptable level of defective products.
A manufacturing organisation sets up quality control systems to ensure production of goods of consistently high quality. This analogy suggests that there is something wrong in the systems and processes for appraisal, structuring, sanction and monitoring of loans by our banking system.
The production process used by banks to ensure that consistently good quality loans are made consists of making a series of judgements or decisions for which banks need to have a governance mechanism that engenders independent and professional decision making and an appropriate conceptual framework for lending.
Both these aspects have been severely hit by the pervasive micro-management practised by the department of financial services (DOFS) and RBI. Having nearly 70% of our banking system in the public sector also does not help. The vitality of our financial markets has got sapped due to the virtual absence of creativity and innovation on account of lack of competition.
The closed, one-size-fits-all framework for recruitment, promotions, pay-scales, to the identical core banking system has left little room for experimentation and innovation, or growth. After all, only open systems can hope to achieve negative entropy!
Governance of our banks has been going from bad to worse over the past few decades.
For the political class, irrespective of persuasion or ideology, PSBs are meant to be milked – for giving cheap loans (before waiving them off) to favoured constituents, which keeps the controllers of the mass vote market in good humour, for enabling generous funding of the friendly corporate sector which, in turn, lubricates the political machinery through donations (now made easier and opaque through use of electoral bonds), and for pump-priming the economy in the absence of sufficient fiscal space.
Public sector does not automatically mean lack of professionalism and accountability, provided governance systems enable and nurture it. The pervasive interference of DOFS and MoF (ministry of finance), with its natural consequence of politicisation of decision making and development of highly patronising relationship between bank management and government bureaucrats, needs to be addressed forthwith.
In the process, professionalism in our PSBs is as good as dead with PSB boards not considered competent enough to select their top managers, leave alone other professional and competent members on the board.
The conceptual framework under which most lending is done in India evolved when banks primarily lent for trade. This 'need based lending' limits assessment extensively evolved as a credit rationing device and not as a credit risk assessment mechanism. Consequently, both debt and equity risk are embedded in the loan portfolios of our banks, while the pricing is wholly linked to debt risk. This naturally leads to a sub-optimally priced loan portfolio, in other words, steady occurrence of NPAs.
There are other contributing factors too. For example, the amount of time and effort spent on ensuring end-use of borrowed funds. One of the prime reasons that money (or credit) is useful is because of its property of fungibility. This makes ensuring 'end-use' very tricky.
The strongly held belief that, since bank liabilities are short term, they should make only short-term loans is also misguided and illogical. First, this hides the fact that managing and profiting from maturity mismatches between deposits and advances is a prime function of financial intermediaries.
Second, most borrowers need both the long-term and short-term borrowings to continue as going concerns. If a bank tries to collect all its short term-term lending, the borrower is unlikely to remain a going concern and the primary security available to the bank goes for a toss.
Succour lies in addressing the broken governance systems. The focus on managing NPAs after the loans have started souring is akin to closing the stable doors after the horse has bolted!
(The author worked with various banks - public, private, and foreign both in India and abroad - for nearly 30 years and is currently on a self-imposed sabbatical to try and understand as to what ails Indian banking and what, if anything, can be done to improve its functioning.)