Why High NPA Levels Are a Cause of Concern for All of Us
One of the key functions of banks is to collect the savings of the society by way of deposits and transfer these to those who can use it productively by making loans and advances. This is the key transformation of capital which enables the society and economy to grow and prosper. This is known as financial intermediation and leads to an all-round win-win situation for the entire society - savers, borrowers, investors and the intermediary. 
 
The main source of earnings for banks is interest earnings on loans and advances which is used to pay interest to depositors and the surplus is utilised first in meeting operating expenses and the balance, if any, is the profit.
 
A non-performing asset (NPA) is a loan or an advance where recovery of interest and / or principal has become uncertain. High and growing level of NPAs implies that there is uncertainty on the ability of banks to return the borrowed funds, leave alone pay the contracted interest on these deposits. 
 
Keeping NPAs low for banks is critical for a number of reasons, which include: 
 
First, NPAs deliver a double whammy to the bottom-line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans. 
 
Second, banks, being highly leveraged entities, have much less room to manoeuvre any fall in operating margins (i.e., the surplus of interest income over interest expenses—also known as net interest margin), something rising NPAs result in. As such, it is important that actual NPA levels are monitored and controlled regularly and closely—both by the banks themselves and the regulators.
 
Third, since the quantum of lendable funds is exponentially inversely proportional to the level of NPA, increasing level of NPAs reduce the lendable funds thereby affecting the liquidity services to the real economy.
 
This liquidity is the essential grease which keeps the economy moving and as it decreases income and employment opportunities in the real economy start getting curtailed. 
 
Fourth, since banks make less income on the remaining portion of good loans the cost of the bad loans is passed on partly by charging higher interest on the good loans and partly by lowering the interest paid on deposits. Therefore, good borrowers have to pay higher levels of interest on their borrowings while depositors get a lower return on their savings! 
 
Fifth, large and continuing incidence of NPAs results in losses and there is a limit to which promoters (government or private) would be willing and able to continue to fund such losses. Consequently there is reduction in the net worth of banks which has repercussions on banks to continue to offer their basic financial intermediation services. Therefore:
 
a) Credit rating of such banks falls, making it difficult for them to obtain / rollover lines of credit— especially overseas lines—thereby making overseas trade difficult and more expensive.
 
b) There is reluctance by overseas customers and counter-parties in accepting letters of credit (LCs) and guarantees issued by such banks – they have to be re-confirmed by other banks which, in turn, come at a cost leading to increase in cost of banking services.
 
c) Customers, especially large institutional depositors, hesitate to keep deposits in such banks.
 
d) Managers of such banks have fewer stakes in the continued well-being of banks as its equity keeps dropping which makes them take on higher and higher risks, pushing the entire economy into a much higher risk level.
 
Sixth, when banks start making losses and are unable to offer reasonable interest on deposits, the public starts looking for alternative avenues for parking their savings. These typically take two forms (a) physical assets such as land or jewellery, or (b) deposits in finance companies. The first may, at times, be a good inflation hedge but is prone to large variations in valuation, apart from being much less liquid. Moreover, these are not productive assets whereby the overall wealth of the society can increase. And, of course, our experience of money kept as deposits with finance companies has never been encouraging. 
 
Finally, banks in their records hold the institutional memory of credit history of all the actors in the real economy. It is very hard and expensive to recreate this institutional memory once lost. When NPAs become so high that a bank becomes bankrupt and has to be closed down, this memory is as good as lost forever. This leads to a break in the payment / credit cycle to and from the various players in the real economy, which in turn, hits the real economy really hard by drastically reducing income as well as employment opportunities in the economy. 
 
Therefore, it is in everyone's interest, and not just of the depositors, to ensure that our banking industry remains healthy.  
 
(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.)
 
Comments
tillan2k
10 months ago
Well said the banks are institutions where fools leave money for rich to luxuriate . the banks are run by white collar crooks , who finance NIGHT bank finance Companies NBFC mutual funds and other casino type operations. often cartoons appear when robbers land to loot banks the manager why not follow the legal path take loans and disappear in England
drptgiridharan
10 months ago
Take the recent case of Punjab and Maharastra coperative bank, LVB vs DBS consolidation and SBI associates merger and other govt owned banks merger of 3 banks into one consolidated bank. They are all indication that bank deposits are no more a safe haven since operatively it is taxable and much lower than inflation rate. Two scenario emerge. One you get peanuts after tax and bank become nuts in using your money profitably. Fixed deposits are at times deposits in fix. It is unsecured item in a balance sheet and there is no charge, collateral etc. As long as you get interest it is ok. The moment bank goes for a toss (likely in future) depositors are at loss.

We can't demand banks or Govt to give back. In LVB, first Lakshmi got eroded due to posting of losses botched and scotched by DBS @ singapore. Tier II bonds were written down and shares got delisted. and finally it lost it's vilasam (mathlab it's address itself) and no more LVB as a banker.

There are many other banks on waiting list and some are RAC. But the fact of truth is that no bank can be said solvent. All in depositors to decide.🙏
drptgiridharan
10 months ago
It is not only a mis match between borrowing and lending mechanism that causes huge NPAs. The asset efficiency theory against the capital gets eroded. After BASEL III norms, there is stronger requirement that capital which is represented by assets shouldn't get eroded. Also RBI is allowing the banks to write off the bad debts. Many beginners suffer to distinguish between what is written off or written down. They differ and defer the picture of NPAs strongly and slowly only depositors begin to realise that deposits have gone as lending and no hope of returning.

In my view there is a popular misconception that deposits are safe with banks than equity investing. Truly and strategically it is the other way. Deposits are insured upto 5L only. Therefore split and spin off deposits in various banks upto 5L is one line. The other is to spread and bid the risk free in post office, LIC, little in gold, SIP, etc can mitigate the risk. Study of bank balance sheet require thorough knowledge as how govt, Pvt and small finance bank operate. In abroad, banks never pay interest on deposits. Depositors have to give interest to banks. There lies your interest in banks in future.
drptgiridharan
10 months ago
It is not only a mis match between borrowing and lending mechanism that causes huge NPAs. The asset efficiency theory against the capital gets eroded. After BASEL III norms, there is stronger requirement that capital which is represented by assets shouldn't get eroded. Also RBI is allowing the banks to write off the bad debts. Many beginners suffer to distinguish between what is written off or written down. They differ and defer the picture of NPAs strongly and slowly only depositors begin to realise that deposits have gone as lending and no hope of returning.

In my view there is a popular misconception that deposits are safe with banks than equity investing. Truly and strategically it is the other way. Deposits are insured upto 5L only. Therefore split and spin off deposits in various banks upto 5L is one line. The other is to spread and bid the risk free in post office, LIC, little in gold, SIP, etc can mitigate the risk. Study of bank balance sheet require thorough knowledge as how govt, Pvt and small finance bank operate. In abroad, banks never pay interest on deposits. Depositors have to give interest to banks. There lies your interest in banks in future.
m.prabhu.shankar
10 months ago
Sushil Prasad Sir - What an article Sir ? So simple. Step by step explanation of the basic functions of the bank very clearly. Ordinary people like me can understand clearly. Thank you, Thank you, Thank you.

Solution to this NPA problem - Everyone knows. Absolutely no interference from the Govt is what is exactly required. How to ensure that. Experts like you should suggest a strategy which is fool proof. Please write another article with the solutions that you have in your mind. Again, Thank you Sir.
sushilprasadassociates
Replied to m.prabhu.shankar comment 10 months ago
Thanks! In short the answer is, there are no magic wands! That is, there are no simple solutions. We have got ourselves in a horribly bind due to a number of factors. All of them are not mistakes. Some of them are outcome of learning.

I am trying to unfurl the various aspects. Keep watching this space.
ramaninv1953
10 months ago
THE AUTHOR SHOULD HAVE SUGGESTED SOLUTIONS ALSO.
shetyerb
Replied to ramaninv1953 comment 10 months ago
One thing is surprise audit of the sanctioned loans within the first year by RBI. I think it is worthwhile for RBI to have a committee of w professionals under one RBI Director.
shetyerb
Replied to shetyerb comment 10 months ago
Not all loans. 3 % of loans at random will serve the purpose reasonably well.
adityag
10 months ago
Sure, I agree. So what's the solution? Bail outs on taxpayers dime? Creative destruction?
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