How bad can the NPA problem get? A research note by financial services firm Antique Finance Ltd says that the concerns are overblown and that “gross NPAs will reach to 4.7% of the total loans in FY10 from the current level of 2.3% and will peak at 5.0% in FY11."

One way to gauge how much NPAs will rise is to consider what happened the last time we had a downturn.

In 2000-01, when GDP growth went down to 4.4% from 6.4% in the previous year, the Reserve Bank of India data show the combined NPAs of public sector banks (in absolute numbers) actually fell a bit.

They increased by 2.4% in 2001-02, when GDP growth was 5.8%, but they fell 3% in the following year, when growth was 3.8%.

There seems to be no simple correlation between NPAs and economic growth, although during the boom years of 2003-07, bad loans with public sector banks went down by a whopping 26.9%.

In 2007-08, however, NPAs rose by 2.9% (again in absolute numbers), a signal that credit conditions had started to decline in the last fiscal year to March.

A closer look shows that there was a big difference between priority sector loans and other advances. For non-priority non-PSU sector loans, NPAs among public sector banks rose only in 2001-02, by 4%. While NPAs on account of non-priority sector non-PSU loans went down by 50% between 2000 and 2008, the bad loans of priority sector advances increased by 6.6% over the period.

It’s rather obvious that small firms fare the worst during a downturn, not only because credit is usually withdrawn from them but also because they are squeezed by large firms. Priority sector loans are, therefore, a millstone around the necks of public sector banks.

Interestingly, the level of NPAs with public sector banks continued to rise throughout the second half of the 1990s. What has been the single biggest change from that decade? Much lower interest rates.

In 1998, for instance, almost 80% of bank loans were at interest rates above 14% per annum. In 2007, that percentage was around 30%. Also, the large gains from their bond portfolios in the early years of the current decade helped banks to make bigger provisions to take care of NPAs at banks.

A recent study by Citi Investment Research on NPAs concluded that banks are: a) still far from peak NPAs (25%, current 2%), and slippages (6.7%, current 2%); b) deterioration correlates more with Index of Industrial Production than GDP/loan growth; c) one-three year lag between economic slowdown, and NPAs peaking; d) lending rates matter (peak 19%, current 14%), but impact limited; e) credit costs are back-ended, they rise even after the economy bottoms; f) stocks underperform with rising deterioration.

At this juncture, banks will be well advised to concentrate on asset quality rather than on growth.

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