Rise in bad loans impairs monetary policy transmission: RBI paper
RBI research paper says the asset quality of banks deteriorated steadily since 2011
Mumbai: Asset quality issues in the banking system, with the rise in gross bad loans, impair monetary policy transmission in India, according to a research paper by the Reserve Bank of India staff.
“The key findings of the study are that deterioration in the health of the banking sector at the initial stages impairs monetary transmission through interest rate channel as banks are able to charge extra credit risk premium for possible loan losses. However, when NPAs keep rising, banks are unable to protect their net interest margins (NIMs) due to competitive pressures, but they become risk averse and cut sharply their lending, which impacts monetary transmission through bank lending channel,” the paper concluded.
The paper was part of the RBI Occasional Papers, which is a research journal of the RBI, containing contributions of its staff. These papers reflect views of the authors.
For the study, quarterly data of banks were assessed between April 2010 and June 2017.
The paper noted, in the second sub-period starting July 2015, banks were not able to protect their NIMs as competitive environment limited on how much extra credit risk premium they would charge to make up for the loan losses. In this period gross NPAs were higher.
According to the research paper, the asset quality of banks deteriorated steadily since 2011, the pace of worsening accelerated following the withdrawal of forbearance for restructured loans in April 2015 and the central bank’s asset quality review in the later part of 2015.
Currently, banks are sitting on a stressed assets pool of over Rs10 trillion.
Movements in NIMs of banks are one of the key indicators of effectiveness of monetary transmission, the paper said.
A bank with low default risk in its loan portfolio will be able to pass on interest rate changes of the central bank symmetrically on its deposits and loans. In contrast, banks with high NPAs will seek to build up provision by increasing risk premium on performing loans, pushing up interest rates and hence the NIM, it said.
“In the process, notwithstanding lower funding costs in response to the policy rate cut by the central bank and comfortable liquidity conditions, banks may not reduce their lending rates or may reduce them only partly, thereby impeding monetary transmission,” it said.