The recent sudden surge in disclosed non-performing assets (NPAs) of public sector banks in India has resulted in strong public outrage. As usual, popular opinion and media analysis, which is influenced by availability bias, seems to blame the greedy industrialists entirely for the mess. Unfortunately, lynch mob mentality is influencing public discourse in this regard. While industrialists must certainly be brought to book, bank management and bank processes seem to have been absolved of responsibility. In fact, the government is infusing more capital in the hands of the same banks that have created the present mess. Our research suggests that capital infusions must be preceded by significant governance changes in the banks. Otherwise, such capital infusions would be tantamount to putting in good taxpayer money after bad.

In a recent research paper on Indian banking—Effects of CEO Turnover in Banks: Evidence from Exogenous CEO Turnovers—we examine the provisioning practices of Indian banks over a decade. We find that provisions created by Indian banks provide little forward-looking information about future NPAs. On the contrary, evidence suggests that provisions in India are being used as earnings management tools. In this paper, we closely examine the provisioning practices followed by Indian banks. We examine quarterly disclosed numbers for 21 banks in India for over 12 years (2001-13). We obtain the required data from the Centre for Monitoring Indian Economy Prowess database. Using careful statistical analysis, we examine if provisions created by Indian banks are forward looking, that is, are current provisions reflecting future NPAs? Or is it the case that provisions are being used as earning management tools to serve the myopic concerns of bank chairmen about their own careers?

Our results are revealing. First, we find that provisions created are not positively associated with future realized non-performing assets. Surprisingly, in some of our tests, we find a negative correlation between current provisions and future NPAs. In other words, banks provision less when the NPAs are about to increase. Surprisingly, such a negative association between provisions and expected NPAs is not found in any of the 23 countries that other studies in this area have examined. Thus, provisions in India do not play an anti-cyclical role, which they are supposed to. This leads to a sudden surge in uncovered NPAs and demands for extra capital exactly at wrong times—times when the capital market conditions are not favourable. If instead, provisions anticipate NPAs, as expected by the Financial Stability Forum, then demand for capital would smoothen out over a longer period of time and hence the stress on capital providers would reduce.

One may argue that it is impossible for bank managements to precisely estimate expected NPAs. To be fair to the bankers, it is true that non-quantifiable information plays a key role in bank lending. It is also true that such non-quantifiable information about the borrowers is actually possessed by the loan officers that originate loans. Often, senior bank officials do not possess such granular, yet non-quantitative, information about the borrowers. This makes it far worse for the senior bank officials to detect future trouble in a timely manner.

However, our analysis of impact of chief executive officer turnover in the public sector banks provides credible evidence against the above argument. We find that in the transition quarter—defined as the first quarter that a new bank chairman is in charge—provisions are not only higher but, more importantly, predict future NPAs strongly. A 1% increase in provisions in the transition quarter is associated with a 0.28% increase in NPAs in the next quarter. As noted before, such an association does not exist in other quarters. If bank chairmen lack information, then how is it that they are able to recognize losses and create forward-looking provisions in their first quarter but not in the following quarters? It seems implausible to us that bank chairmen know more about loans lent during the tenure of their predecessors but not about the loans extended during their own tenure. A more reasonable explanation is that the bankers are more truthful in disclosing bad news pertaining to their predecessor’s tenure than their own.

Our third finding is that provisions co-move significantly with profits before provisions. This implies that bankers provision more when the profits are higher and less when the profits are lower. The literature in financial accounting terms such behaviour as “earnings smoothing". The idea here is that bank chairmen aim to show a clear and smooth trend of increasing profits by using discretionary items such as provisions as devices for smoothing earnings. This leads to reduced provisions when the earnings are lower than the target and increased provisions when earnings are higher and hence completely distorts the reported bank numbers. In documenting these findings, we control for the mechanical correlation between profits and NPAs, which may arise as a consequence of loose lending in good times.

As pointed out by the P.J. Nayak committee, it is important to recognize that faulty processes in banks are as much responsible for the current mess as is the strategic behaviour of large borrowers. In fact, the committee had pointed out two years ago that the actual NPA situation is far worse than what the banks were revealing at that time. We sincerely hope that both the bank boards bureau (BBB) and eventually the bank investment company (BIC) will think carefully about how distorted incentives of senior bank management leads to such egregious accounting.

Only deep and careful thought about the origins of such practices can lead to solutions that prohibit the same. Moreover, the officials of the Reserve Bank of India that undertake the annual inspection must be sophisticated enough to be able to ferret out such accounting practices.

Krishnamurthy Subramanian and Prasanna Tantri are, respectively, member of the P.J. Nayak committee and associate professor of finance, and senior associate director at the Indian School of Business.

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