The severity of the NPA crisis
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To understand the extent of the non-performing asset (NPA) problem in the Indian banking sector and come up with solutions, it is important to have a good measure of the problem. While the standard measures have their uses, they do not answer the question that everyone seems interested in: How severe is the NPA crisis? We propose a new measure—the ratio of NPAs to bank capital. This measure shows that the crisis is indeed severe, among the worst in India’s history.
Traditionally, two metrics are used to assess the scale of the problem—the ratio of NPAs (gross or net) to gross domestic product (GDP) and the ratio of NPAs to total loans. The ratio of NPAs to GDP measures the potential losses in relation to the size of the economy. This is especially useful in cross-country comparisons, given that countries are at different levels of GDP. The problem with this measure is that it does not indicate whether banks are able to handle the NPAs with their own resources—their capital.
A more commonly used metric is the NPA to loans ratio. This shows the fraction of bank loans that has turned bad. One shortcoming of this measure is that it suggests the problem can be solved through denominator management—growing the loan books of banks to make the NPA ratio smaller. This growing out of the problem approach is not a reliable one. It depends on the overall economic environment and on the demand for credit. It assumes that the source of the NPA problem is external to the banking system and not in the weaknesses of the lending processes. If the demand for credit is slow it becomes difficult for the banks to grow their loan books. Even if the demand for credit were high, it would be difficult for the NPA-ridden banks to grow. Prolonged NPA episodes erode banks’ capital and constrain their ability to grow their loan books.
In sum, the standard measures do not convey the full picture and can be misleading. A high level of NPAs in the banking sector need not necessarily create a crisis situation, if the banks have the capital needed to provision for the losses. Bank capital is also a key factor in resolving the banking crisis. Hence, banks’ ability to withstand NPAs is best measured in relation to capital.
In the graphs we plot the ratios of gross NPAs (GNPA) and net NPAs (NNPA) to bank loans and to bank capital for the last 20 years. We have also added the amount of restructured loans to GNPAs in both the panels from 2007 onward.
To understand the importance of the NPA to capital ratio, we compare the depth of the NPA problem across two banking crisis episodes in India. The banking sector had witnessed an NPA crisis in the mid to late 1990s. The surge in bank NPAs at that time took place in the aftermath of the introduction of robust income recognition and asset classification norms which exposed two decades of bad loans.
The NPA to loans ratio suggests that the current crisis is considerably less severe than that of the late 1990s. However, when NPAs are measured in relation to bank capital, the current crisis looks just as bad. In particular, the deterioration in the balance sheets of banks post-2010 is much sharper when measured using the NPA to capital ratio.
The drop in the NPA to capital ratios in 2016 looks hopeful but this is partly due to the additional capital received by many public sector banks as part of the government’s Indradhanush programme. Also, in light of the revised disclosures of NPA levels by some large private sector banks in the last few weeks, the 2016 ratios are likely to be much worse.
We also compare the growth rates of NPAs, capital and loans across the two crisis episodes. The average annual growth rates of GNPA and NNPA over the five-year period from 1997-2001 were 8.5% and 9.8%, respectively. During this period, bank capital grew 13.14% and bank loans grew 15.87%. The corresponding numbers for the current crisis are much worse. The average GNPA and NNPA growth rates for the period 2011-2015 were 45.9% and 54.9%, respectively. The average growth rate of bank capital for this period was 16.1%. Bank loans grew at 16.2%.
This shows that during the last NPA crisis, bank capital grew at a higher rate than NPAs. While the NPA to loans ratio was higher then, banks were not undercapitalized. They had better ability to withstand the problem. In the current crisis, however, the growth rate of NPAs has been considerably higher than that of bank capital, further underscoring the severity of the crisis. The growth rates of bank loans on the other hand have been similar across both crisis episodes.
The emphasis on the alternative measure of the NPA problem also highlights the importance of capital in resolving the crisis. If the NPA to capital ratio is to be restored to a level that was prevalent during the high growth years of 2003-2007, the capital base has to roughly quadruple. Even if we assume that roughly 50% of the net NPAs will be recovered by the banking sector, the capital base has to double. This is unlikely to happen through retained profits or sale of real estate or other similar strategies.
An attempt to revive the banking sector must include a credible commitment of capital for it to be meaningful. In absence of capital and accompanying structural reforms, any solution will be incomplete and the banking sector may remain in the quagmire for a long time to come.
Harsh Vardhan and Rajeswari Sengupta are, respectively, with Bain & Co. and Indira Gandhi Institute of Development Research.