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A Glitch in the Banking System: Inside India's NPA Crisis

Jan 21, 2022 2:35 PM 5 min read

A non-performing asset (NPA) is simply an asset that has stopped generating any income for a bank. More formally, an NPA is a type of debt (loan) that is in default i.e., there is a failure in repayment of either the principal amount or the interest. In India, a loan is classified as an NPA if the payment remains overdue for a period of 90 days. 

Banks generate their income primarily from the interest they receive from loans. Hence, NPAs affect the ability of banks to generate income. NPAs lower the liquidity of the banks, and consequently lower their lending ability. This leads to the diversion of funds from good projects to bad projects. In addition, these look bad in the bank’s balance sheet and erode the confidence of the shareholders and depositors. Ultimately, the consumer has to suffer, as banks charge higher interest rates to counter their losses. NPAs also have the potential to put banks in a severe crisis as panic among depositors forces them to rush to banks to withdraw money, a condition known as “Bank Run”, further aggravating the crisis leading to bankruptcy.

How Deep in the Water Are We and Why?

The value of NPAs in the banking sector amounted to INR 8.34 lakh crores, out of which, INR 6.16 lakh crores is contributed by public sector banks. The Gross NPA ratio was 7.5% in 2021 and is expected to reach 9.8-11.2 % by March 2022. If we trace back the roots of the NPA crisis we find them right back to the mid-2000s. During this period, the Indian economy was flourishing and banks started lending extensively to companies primarily in the infrastructure and real estate sectors to drive their growth. Then, the global financial crisis happened in 2007-08 and the economy came to a standstill. Added to this were the land acquisition and environmental clearance issues. Many companies were unable to meet their obligations and henceforth started the NPA crisis

“Crony Capitalism” has also contributed to NPAs, where political pressure forced banks to give loans to individuals and corporates without properly evaluating them, furthering the risk of default. These factors have led to what is called the “Twin Balance Sheet” problem. As the name suggests, the problem is due to the interdependence of corporations and banks. Due to the sluggish growth of some corporations, they are unable to pay back their loans. We will look at the drastic impact of NPAs from a recent incident involving Yes Bank.

 

The ‘Yes Bank’ Fiasco

Yes Bank was the fourth largest private sector bank at the time of the crisis. The bank started lending heavily to stressed companies such as DHFL and Anil Ambani Group, hence its asset quality declined and NPAs piled up. In 2017, the RBI noticed the irregularities and in 2018 the erstwhile CEO was removed. This lowered the confidence of the existing depositors and they started withdrawing their money. The effect was such that the bank loaned more than its deposits in FY 2018 and the stock prices went down.

All this prompted RBI to take control, and it imposed a month-long moratorium on the Bank in March 2020 (A moratorium refers to the ceasing of all regular activities of the bank). The withdrawals were capped at 50,000 per person to prevent the situation of a “bank run”.

Ultimately, SBI at the behest of the government had to bail out the bank by buying a 49% stake. The government had to take timely action to avoid the collapse of a major bank which would have adversely impacted shareholders, depositors and employees. More importantly, it would have eroded the confidence of people in the Indian banking system.

 

What Are the Ways to Prevent NPAs?

To minimise the occurrence of NPAs, a proper and transparent evaluation of the company’s financials and its past records must be done before arriving at a decision. Once the loan has been sanctioned, constant monitoring is required to identify potential defaults and take steps in mitigating them beforehand. 

In the words of Raghuram Rajan, former governor of RBI:

A banker who lends with the intent of never experiencing a default is probably over-conservative and will lend to too few projects, thus hurting growth.

NPAs are inevitable in any economy, and more so in the case of a growing economy like ours. 

 

If NPAs Are Unavoidable in an Economy Then How Can We Resolve Them?

NPAs can be countered using various legal provisions.

Insolvency and Bankruptcy Code was enacted in 2016 for efficient resolution of bankrupt companies i.e., companies who are unable to pay off their debts. Resolution is carried out in a time-bound manner (270 days) and involves the stakeholders- creditors, debtors and employees. The proceedings are carried out by the National Companies Law Tribunal (NCLT), in the case of companies and Debt Recovery Tribunal (DRT), in the case of individuals. The Insolvency professionals appointed by the NCLT, administer the bankrupt company for the time defined. The entire process is completed under the guidance of the Insolvency and Bankruptcy Board of India (IBBI) which consists of representatives of the government and RBI. 

Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002, known as SARFAESI Act, enables banks and other financial institutions to take control of the collateral asset that was agreed upon at the time of lending. The asset may be sold, leased or managed to recover the cost of default. Another important aspect of this act is the creation and regulation of Asset Reconstruction Companies (ARC). 

An ARC is a financial institution which ‘buys’ NPAs from banks, i.e., NPAs are transferred to the ARC at a mutually agreed price. ARCs help clean the balance sheet of the bank and aim to recover as much default as possible. Currently, there are 29 private ARCs in India, but certain problems plague them. Firstly, they solely act as recovery agents, as they don’t have enough funds to restructure the company. Secondly, the recovery rate of these ARCs is dismal and often the NPAs of the public sector banks are sold at heavy discounts to the private ARCs.

 

The Bad Bank - An Ambitious Step Towards NPA Resolution

One of the key features of the 2020-21 Budget was the announcement of the setting up of a ‘bad’ bank by the Government. Primarily, the public sector banks will be provided services and a major stake will be held by them. The highly anticipated ‘bad’ bank is backed by INR 30,600 crore of government guarantees. It will procure INR 2 Lakh Crore worth of NPAs out of which 15% will be paid immediately in cash and the rest as government securities. This institution has the potential to dampen India’s NPA crisis if implemented properly in a time-bound manner.

There are several benefits of this such as proper valuation of NPAs during purchase, a fresh infusion of capital in the banks at the time of acquisition and transfer of any excess capital from the recovery process to the banks. On the other hand, there are several other hurdles such as the challenge of moral hazard, whereby banks will be tempted to lend to risky projects, expecting the government to bail them out. Critics argue that such institutions do not address the root cause and just shift the problem from one place to another.

Moreover, the bad bank is backed by the government, so if not properly implemented it will lead to direct loss of the taxpayers’ money. How the bad bank will fare is a question which we will only find the answer to in the future.

 

Written by Yajur Tayal

FIN.
 

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