With the proliferation of financial reforms under the umbrella of the Basel II Accord on banking supervision, the focus of banking has shifted quite dramatically from size and growth to prudential practices.

Graphics: Ahmed Raza Khan / Mint

With accounting prudence being followed, banks are more cognizant of both their quality of assets and possession of capital. The number of non-performing assets (NPAs) is important as they speak a lot about the credibility of the system. The build-up of such assets has invariably resulted in financial crashes and, therefore, there has been considerable discussion on reining in NPAs. Capital adequacy is the other measure of soundness of banks as they need this base to build their balance sheets. Hence, for future expansion banks do require to build their capital base, proportionate to their assets.

Usually, both these concepts—NPAs and capital adequacy—are looked at independently, as they indicate separate issues. However, the two can actually be linked which, in turn, provides a different dimension to the health of banks. We normally talk of NPAs as a percentage of total advances while capital adequacy is in terms of the base, or denominator, available to support the risk-weighted assets. This can be misleading because a bank can explode its denominator and still show a low NPA ratio in the conventional sense. Further, a bank showing a high capital adequacy ratio (CAR) may have built up toxic assets, which CAR does not reflect.

The two can actually be put together. NPAs per se reflect the contaminated part of the portfolio, which can be juxtaposed against the available capital that belongs to the bank. The idea here is that capital is what the banks actually own—gross NPAs should be adjusted to arrive at the available free capital. Therefore, to begin with, the ratio of gross NPAs to capital (where capital is defined loosely as the sum of equity and reserves) is critical. This gives the extent to which the bank’s own capital is being blocked by its impaired assets. A similar measure was developed by Gerard Cassidy at Canada-based RBC Capital Markets and termed the Texas ratio: Here, NPAs were pitted against the capital as also loan loss reserves, or reserves meant to cover losses on the portfolio. A Texas ratio touching 1 indicates that the bank is in deep crisis.

The ratio of gross NPAs to capital has been used here in the broader sense to show how much of capital would be erased by NPAs—this can be termed the “knock-out ratio". This narrow definition of capital takes into account largely what the Basel Accords define as tier I capital—the core capital of a bank, which is equity and disclosed reserves. This would exclude tier II capital, which takes into account subordinated debt, loan loss reserves and perpetual preference shares. With this ratio so defined, the accompanying table examines the vulnerability of some of the leading Indian for fiscal 2009. The table also extrapolates, in crude terms, what CAR would look like in case NPAs were deducted from the capital of the bank—this is the adjusted CAR. Gross NPAs have been subtracted from capital and the corresponding CAR ratio has been calculated in the absence of information on actual capital and risk-weighted assets of banks.

The table shows some hard-hitting facts. First, for the Indian banking sector as a whole as represented by 39 banks (27 public sector and 12 private, including six new private banks), the average “knock-out ratio" (NPAs to capital) was quite high at 20.4%. Second, 14 banks had ratios above this average; another eight were within a range of 2 percentage points below this average. Five of the six new private banks were below the average—indicating that their wherewithal to grow prudently was higher. Third, under the concept of adjusted CAR, six banks now slide below the 9% mark that Basel II stipulates—these banks were in the clear with the conventional CAR—and 11 have adjusted CAR in the single-digit range between 9% and 10%. This means that while only one bank had a single-digit CAR, there are now 17 with adjusted CAR less than 10%. Fourth, the median decline from conventional to adjusted CAR was 2.42—the average decline was 2.6—with the highest being 6.86 for Development Credit Bank and the lowest being 0.87 and 0.9 for Yes Bank and Indian Bank, respectively.

Quite clearly, the capital situation of our banks looks less glamorous with these adjustments. In the future, it may be useful for the Reserve Bank of India to work on the concept, and have banks calculate their unimpaired capital adequacy ratio. A variation of this could be presented: adjusting for net NPAs after provisions for the bad debt have been made.

Against the background of the financial crisis, it does make sense to pay more attention to these ratios, especially CAR, as this measure has been used to show the solvency of banks. By not netting out the existence of toxic assets, banks may be overstating their positions, which may camouflage the true picture. Lehman Brothers, one must remember, had a very high CAR when it went down.

Madan Sabnavis is chief economist, NCDEX Ltd. Views expressed here are personal. Comment at theirview@livemint.com