The Roller Coaster Ride of Non-performing Assets in Indian Banking

Executive Summary:

This paper narrates the story of the roller coaster ride of non-performing assets (NPA) of the Indian banking sector. Three distinct phases of intertemporal broad trends can be discerned in NPAs of the Indian banking sector. First, since the initiation of financial sector reforms till about the beginning of the North Atlantic Financial Crisis (NAFC), NPAs showed a consistent downward trajectory. Second, during 2008-09 through to 2017-18, they showed a distinct spurt. Third, since 2017-18, NPAs have been on a downward trend till 2019-20, until the economic disruptions caused by Covid 19. In contrast to the popular practice of treating the second phase of rising NPAs as emanating exclusively from governance issues in public sector banks (PSBs), four factors have been identified: (a) falling commodity prices; (b) regulatory forbearance; (c) initial exuberance in infrastructure projects punctured by a downward phase in business cycles (leading to substantial debt accumulation of select big corporates); and (d) governance failure in select PSBs. Moving forward, while the pandemic and some of the associated policy measures could reverse the recent downward trends in NPAs temporarily, more durable policy initiatives like bankruptcy reforms are expected to make significant positive changes in the NPA situation of Indian banks.

Unlike a real sector corporate firm, a commercial bank is a highly leveraged business entity. Being primarily funded from deposits, the extent of leverage in a bank works in opposing ways – on the one hand, higher leverage makes the bank more profitable, and on the other it makes the bank more vulnerable to bankruptcy risks. Impairment of, say, 10 percent of a bank’s assets can significantly erode its net worth. Thus, the quality of a bank’s assets (comprising primarily of loans
and investments) is of utmost importance from the standpoint of the health of the bank and of the aggregate financial sector. Non-performing assets of banks reflect the quality of their respective loan portfolios, and of the banking sector in the aggregate, thereby constituting one of the critical indicators of financial stability.

Thus, high leverage is crucial to bank’s business. In undertaking its core functions, a bank offers intermediary and liquidity services, in which one of its key activities is its capacity to do maturity transformation. Banks often invest in longer-term assets that are funded by short-term liabilities. Thus, they are exposed to various risks – credit, operational, market, and liquidity. In an economy where the banking sector is dominated by public sector banks, credit risks are of critical significance: these risks often get transformed into fiscal risks. Moreover, if key segments of the portfolio of a bank turn bad, its high leverage can lead to effective insolvency or bankruptcy. Finally, in the case of interlinked lending, the presence of non-performing assets (NPAs) in a bank’s portfolio can have economy-wide repercussions.

While the health code system of classifying banks’ assets was introduced by the RBI as early as November 1985, the issue of NPAs came into the limelight after the publication of the Narasimham Committee Report- I (1991). The Committee noted that the classification of assets according to the existing health code was not in accordance with international standards. Accordingly, a prudential system which included the recognition of income, classification of assets, and provisioning for bad
debts was introduced in financial year 1992-93 (RBI, 1993). It revealed that the NPA position of commercial banks in the early 1990s was actually far worse than it is today: as on March 31, 1994, the gross NPA-assets ratio of all public sector banks was as high as 25 percent, compared with 7.5 percent at the end of March 2021. Improvements in NPAs had clearly taken place at a slow and steady pace starting in the mid-1990s.

The inter-temporal trajectory of NPAs in Indian banking during 1992-2018 followed a distinct three-phase pattern. Data on the extent of NPAs in Indian banking are meagre before the mid1990s, as there was no appropriate classifications of NPAs at the time. Following the economic reform measures of the 1990s, in which financial sector reforms occupied a key position, there was a significant improvement in the extent of NPAs in Indian banking. This falling trend in NPAs continued till around 2009, after the advent of the North-Atlantic financial crisis (NAFC) of 2008. NPAs started rising after that, initially at a slow pace (perhaps reflecting several measures of regulatory forbearance), and at a faster rate from 2014 till about 2018. Various factors were responsible for the unabated rise in NPAs during 2010-18, prominent among which were: (a) the fall in commodity prices; (b) prolonged regulatory forbearance; (c) failure of public-private partnership projects in some key infrastructure areas; and (d) governance issues in commercial banks (Mohan & Ray, 2019). Later, from 2018, coinciding with the initiation of progressive bankruptcy measures, the trend in NPAs improved once again, until the Covid 19 pandemic hit in 2020.

A popular narrative about the sharp rise in NPAs during 2010-18 is that banks suffered due to bad governance in public sector banks (PSBs). However, the issue with this narrative is that it is not consistent with the sharp fall of NPAs recorded by the same banks during the period 1996-2010. How could such an improvement take place in the NPAs of PSBs over a decade and a half? What changed in the governance of PSBs over that period? Did the governance of PSBs change drastically after around 2010? Was it accidental that PSBs did well for so many years?

It is here that the role of two specific factors needs to be highlighted. First, there was a significant expansion of large corporate sector lending after the late 2000s, including for lumpy infrastructure projects under public-private-partnerships (PPPs) as a matter of public policy. Such lending could have led to unforeseen problems with the slowing down of the economy and fall in some key commodity prices. Second, the phenomenon of regulatory forbearance from 2008, in the wake of the North Atlantic Financial Crisis (NAFC), camouflaged the real dimension of the problem and could have engendered a false sense of complacency and the related low measurement of NPAs. Later, credit growth started slowing down along with a deceleration of the GDP growth rate.

Against this context, the present paper looks into the intertemporal behaviour of NPAs over the period, 1992-2020. For expository convenience, the structure of the paper is as follows. First introduces the paper, while second discusses the broad trends in NPAs over time and identifies the twists and turns. There is a short discussion of the improving trends in NPAs during 1992-93 to 2008-09; followed by enumerating the major reasons for the emergence of NPAs in Indian banking during 2008-09 to 2017-18. The authors discuss the recent improving…., and conclude with the way ahead.