The NPA Chakravyuh

The Analysis of bad Debts in PSBs and Consolidation for Tackling

NPA Problem

The Lending Mechanism

Bank lends to the individual and institutions according to their capacity to repay with interest.
The mantra is simple but the complexity of the project undertaken or the purpose for which the
money is to be borrowed makes it difficult to gauge the factors that should be taken into
consideration. Hence the bankers use different norms while lending, often based on the future
income predictions. This is common and the most widely used mechanism worldwide for flailing
the monetary needs of hour. Post LPG reforms, when the license and quota cap has been
removed Indian bankers have more or less same approach of lending. Problem occurs only when
such future predictions fail due to unforeseen circumstances or the businesses pass through
cycles of long time intervals where such predictions have poor confidence intervals.

Problems such as bad loans, defaulters and non-repayment of the dues has always been there, it’s
now that the quantum of amount deferred due to such lending has become severe headache for
the banks. In order to get rid of such loans, back in 2002, Reserve Bank of India (RBI) Governor
Bimal Jalan had come up with the Prompt Corrective Action (PCA) Framework, a set of
mandatory action plan for troubled banks, which was subsequently tightened to take form up to
the latest Insolvency and Bankruptcy Code (IBC) in 2017.

The major change witnessed during this whole process is that the central bank, RBI used to focus
on the banks earlier, which now has chosen to adopt the bifocal policy under which the action
may be taken against both the borrower and lender, directly and without delay.

Under the PCA Framework which was followed until the late 2015, the RBI used to cut down on
the Directors’ salaries, dividend distribution, and remittance of profit at first Risk Threshold. In
second Threshold the branch expansion would be reined and the merger used to be enforced by
the RBI in the worst possible scenarios, termed as discretionary action. In the third threshold,
these Risk Thresholds would effectively restrict the CRAR, monitor asset quality and
profitability as well as put limits on leverage rations.

But the PCA Framework did not yield the expected results at the expected pace. Primary reason
was the “too big to fail” mentality of the banks. As the PCA Framework suggested the action
against the banks and not much at the lending end, hence it was the need of the hour to tactically
shift the focus to the lending end of the banks.

Similarly, with the PCA Framework gaining momentum, the focus was shifted to the borrower
side using the SARFAESI, where banks had the authority to liquidize the pledges assets and
recover the dues. Later the RBI came up with the Debt Recovery Tribunal (DRT) which was
instituted in good faith but choked in itself due to loose ends.

One problem is the small number of DRTs and Debt Recovery Appellate Tribunals, where
judgments of DRTs can be appealed. While there are 33 DRTs, there are only 5 Debt Recovery
Appellate Tribunals in the country. The biggest challenge, it appears, is the ability to deal with a
subject with speed. Only genuine cases with both willingness and ability to repay should be
allowed to proceed to the DRAT or else the Debt Recovery system will not recover from
bureaucracy and red - tapism. The challenge is that our judicial system is both choked and has an
inadequate pace for giving out decisions, which slows down any further redressal. Recovery can
be speeded up only when there is a fixed time-frame for all disposals, and realisation of assets
could be speeded up by having special courts to deal with such recoveries. Performance
indicators of the adjudicating officer could be used to improve the efficiency of the system.

Strategic Debt Restructuring was another attempt from the central bank to give enough window
to bad loans to recover but instead resulted into what is called as evergreening of the loan, i.e.,
a loan that does not require the principal amount to be paid off within a specified period of
time. Evergreen loans are usually in the form of a short-term line of credit that is routinely
renewed leaving the principal remaining outstanding for the long term which further stressed the
bank balance sheet. The SDR was able to solve only 2 cases while the number of stressed asset
was touching the all-time high.

The unique idea of Joint Lending Forum (JLF) was also pitched so that the borrower would be
pressurised collectively by the forum which will look for the financial interest of the lender.
Although the idea was good, the consensus could not be met between the lenders and hence, the
JLF could not yield much.

Not to mention, all the lenders were feared by the infamous 4Cs – Courts, CBI, Card Verification
Code and the Comptroller Audit General. With the reporting in media gaining momentum, it was
utmost priority for both the lenders and RBI to come up with a solution to curb the NPAs and
roadmap to enforce the financial interest of the bankers and maintain the faith in the banking
industry without taking any chance for the bank run-offs.
Introduction to NPAs

What are NPAs?

NPA stands for Non-Performing Assets. Assets are the entities possessing monetary values and
owned by the banking institutions or NBFCs. When bank lends to the borrowers, individuals or
organisations, the borrower pledges the entity equal or more than the value of the loan to the
bank as a collateral in most cases. Leveraged buyouts usually don’t have any sovereign backing
by a physical asset.

When the borrower is paying back the amount owned by him regularly to the bank, the loan is
said to be secured. A pledged asset does not directly get the status of the NPA. The asset is
classified as NPA only when it doesn’t fulfil the purpose with which the money was lent to the
borrower. This is quite a complex scenario and may have multiple interpretations depending on
the type of assets created post the borrowing. The types of NPAs are as follows:

Standard Assets – Assets which are generating regular income to the bank
Sub-Standard Assets – Assets which is overdue for a period of more than 90 days but less than
12 months
Doubtful assets – An asset which is overdue for a period of more than 12 months
Loss assets – Assets which are doubtful and considered as non-recoverable by bank, internal or
external auditor or central bank inspectors

Sub-standard assets, Doubtful assets and Loss assets are NPA.

For example, an Infra Project may take longer than usual period to payoff and hence may get
classified as ‘Earning’ where the information about the earning is not backed by any standard, as
the borrower gets the post his own predictions of the usage that he deems to be earning. Thus
classifying an asset as NPA is crucial job.

When the assets fails to yield the projected outcomes, the identification of the stressed asset is a
process of complex decision making which starts with the lender termed under “Special Mention
Account” if the loan repayment is defaulted for 60 days. These SMA then gets labelled as NPA
post 30 days of notice post SMA status. The lender or account which remains as NPA for 12+
months then gets status as “Substandard” loan account.

If the account remains as “Substandard” for a year then the bank classifies the account as
“Doubtful” mostly considered beyond the recovery aspect of any bank. Although the account is
termed as loss making only if the Auditor, RBI and the Board of Directors of the bank terms it
so. These technicalities involved in the process of classification of a particular asset as Non-
Performing and later as Loss have resulted into escape-window for a lot of borrower to take a
smooth exit.
Gross NPAs of public sector banks increased to ₹ 606,911 Cr while total stressed assets (gross
non-performing assets and restructured standard advances) of scheduled commercial banks were
₹ 9.64 trillion as on 31 December, 2016. As of September-end, the banks’ total stressed loans
were ₹ 897,000 Cr. This is a 7.5% growth in stressed loans from September to December-end.

Steps taken till date

RBI in September 2015 came up with the 3R Framework for revitalising stressed assets. Those
3Rs were Rectification, Restructuring and Recovery. It can be seen from the current situation,
RBI is done trying the first two on the top layer of NPA accounts and hence has shifted the focus
on the third and most optimistic solution to liquidise the asset, recovery through Insolvency and
Bankruptcy Code.

During the rectification of the loans, the lender is given the benefit of doubt and offered more
time frame for repayment of loan with no change in the EMI or interest, the reason being that
genuinely stressed businesses should get the window of opportunity to come of out of the vicious
cycle of bad loans and avoid evergreening of the loan.

During the restructuring phase of the NPA management, the regulatory bank further eased the
tenure, the rate of interest and also shifted the amount of loan to the bigger players ie the
stakeholders of the business where they can manage to repay the loan if the restructure happened
in a strategic manner. This involved the conversion of the debt to equity in some cases and
further lead to ultimate ownership change where chance of the loan repayment increases.

With these two approaches yielding few or no results and NPA sailing through the all-time high,
RBI came up with the decision to give more powers for the existing Sarfaesi act of 2002, which
subsequently came up with the DRTs, where banks had the authority to go for the liquidation of
the assets by putting them up for auctions where the hair cut for banks is low and the process is
much faster than the rest. The Sarfaesi became an advocated tool mostly in case of immovable
assets and the mortgage backed loans where the recovery was made quickly and its major reason
as to why the consumer loans stand at much lower levels when it comes to NPA in a broader
picture.

In October 2015, RBI started conducting the Asset Quality Review of the stressed asset of
different banks. If the RBI finds that the lender is unable to repay the loan due to lesser cash
flows or many other operable reasons, RBI would infuse more capital or find a new investor for
the project so that the business may get possible cash flow under the new management. But in
such cases, the interest rate or the tenure of the loan does not undergo any change. Hence the
business world is less responsive to the decision of the RBI.

Under the second R, that is Restructuring, the tenure for the infra loan would be renewed or
extended to the longer period of 25 years but the review would be conducted post every five
years.
Similar was the case with the SDR, where the debts were restructured in a systematic way so as
to allow the repayment of the loan with interest by altering the tenure of the loan. More number
of cases got involved with the conversion of the debts into equity and thereby changing the
ownership of business. Later in June 2016, under s4a scheme, only unsustainable portion of the
loan would be converted to equity preference share and the ease of the business would not be
altered over the ownership. This placed somewhat better confidence in the business houses to
assure them that their businesses won’t be taken over by the banks.

Problems faced in SDR

The basic concept of SDR was to restructure the debt in the manner that it will be repaid and that
the bank does not incur a loss of revenue. Hence the debt will be altered using the basic items
like the mortgage pledges, owner’s quotation and the terms of the loan. Hence the debentures so
placed will be converted into preferential shares of the new entity resulting into direct change of
ownership. In addition the terms of loan like the repayment period and the interest charged won’t
be altered in other terms, the owners of running houses of these businesses would be changed. To
accommodate the ownership of these large loss making businesses, the big players with a huge
paid-up capital will be needed. From this brainstorming, emerged the concept of bad bank or the
PARA as called in the Economic Survey, although it was assumed that RBI will back the idea of
such bad banks, the idea never took off. Even after the loans started restructuring, the amount of
NPA did not fall; hence it is evident that the idea is not working in the way it was supposed to do
so.

This further led to the foundation of the Sarfaesi Act of 2002 post the recommendations of the
Narasimham Committee which gained momentum post the decision making powers of the banks
were elevated. Securitization and Reconstruction of Financial Assets and Enforcement of
Security Interest Act of 2002 allowed banks to obtain cash through the liquidation of secured
loans or mortgage backed loans only in the banking and the NBFCs. The idea was not a major
success because most of the loans under the consumer section are not NPAs or even the SMA as
a matter of fact. This can be stated as the fact of “Credit discipline” by the consumers. But the
Sarfaesi could not be applied to the loans of the big corporates as these large loans cannot be
backed by the security or mortgage of any assets, as such loans are meant for asset creation.

In the case of corporate loans, under the Sarfaesi act, the loans are handed over to Asset
Restructuring companies (ARCs) but combined efforts of the ARCs and DRTs did not harvest
anything significant as the process flow in these recoveries was very slow. The data from the
economic survey suggests the same.
IBC 2016

In order of step out of the vicious cycle of bad loans the next step was the Insolvency and the
Bankruptcy code of 2016. This code was a modified and an improvised version of the ARCs and
DRTs with laws good enough to recover the debts but strict at the same time to avoid the further
appeal mechanism just to avoid the action against bad debts.

The IBC 2016 was so formed that the loan defaulter cases can be fast tracked to minimize the
losses. The process started with the appointment of an Insolvency Professional once the loan
account is declared default. After the IP is appointed the lender would be given a moratorium
period of 180 days and further grace of 90 days. Once the moratorium period is over, the IP will
decide which approach to follow and accordingly the loan will either be restructured, the interest
and tenure will be changed or the new investors with adequate capital and expertise to run the
business will be found. Once the initiation for the insolvency is kicked off, the further process to
liquidate the asset would be decided by the IP. Appeal to such IBC cases is heard by the NCLT,
a quasi-judicial authority.

Barriers in Loan Recovery

Provisions of both the IBC and Sarfaesi are not applicable to agricultural loans. The tractors’
loan which consists a major part of agricultural loan accounts, almost ₹ 6000 Cr of bad loan that
are not recovered. Banks were made ready to take up to 40% as hair cuts or One Time Settlement
over these bad agricultural loans although only ₹ 800 Cr could be recovered so far. Plus regular
announcements of the loan waiver by the governments create a habit of poor credit discipline.
Although the balance sheets of the banks are cleared for a while but they suffer in the long runs
as a tendency to repay the loan gets poor every time.

Loan write off is another barrier in the loan recovery process. For instance, the balance sheet of
the bank is cleared and the bank is used to save the erstwhile Capital Gains Tax, but the tendency
of the bank officials not to recover the due amount with the same mentality as the taxes are to be
paid only when the amount is recovered. Hence the banks go for loan write offs which can be
eventually seen as it getting settled as loss for the bank.

Similar is the case with the willful defaulters. Every defaulter is not willful defaulter but Loan
can become bad loan out of bad luck, regulatory clearance, partners' betrayal, time and cost
overruns. Entrepreneurial wealth is not sinful. But each should have opportunity, by this noble
thought process, the willful defaulters are to be given the room for activity, many cases are
recovered through such noble approach.
The measures could include a combination of capital-raising from the market, dilution of
government holdings, additional capital infusion by the government, mergers based on strategic
fit, sale of non-core assets, etc.

The government is pushing for consolidation among the state-run banks in order to help the
lenders gain efficiency and scale, and operate without the support of repeated capital infusion to
bolster their balance sheets.

The government is reported to be mulling creating six large public sector banks of global scale,
also with an aim to help the smaller banks with weaker balance sheets get support from the larger
ones with strong finances.

1. Banks to be merged should cover same regions.

2. Asset quality of the entities to be merged should be comparable.
3. Capital adequacy of the banks to be merged should be comparable.
4. Profits of the banks to be merged would also be considered.
In 1998, a committee headed by M Narasimham had recommended a series of reforms needed to
strengthen the banking sector. Among them was a need to consolidate banks in a way to create a
handful of large national lenders and a few strong regional lenders. The committee had also
urged the government to allow these banks to function with greater autonomy.

PJ Nayak Committee, which submitted its report in 2014, had noted that the government needs a
radically different approach towards state-owned lenders if it hopes to reduce the fiscal burden it
incurs due to the constant need to recapitalize these lenders.

The gross NPA ratio of public sector lenders range from 7 percent to 24 percent across banks.
IDBI Bank has the highest bad loan ratio of 24 percent while Indian Bank has the lowest ratio of
7.2 percent.

The credit agency, part of S&P Global, estimated that banks have provisioned for only around 40
percent of their exposure to these assets.

Based on the assessment of the embedded value in the top 50 NPA cases, it is estimated a 60 per
cent haircut would be needed on these loan assets. That would mean banks will have to increase
provisioning by another 25 per cent this fiscal, compared with nine per cent in the last fiscal.

The gross non-performing advances (GNPAs) of public sector banks continued to display the
highest level of stressed advances ratio at 14.5 %, compared to private and foreign sector banks
that recorded stressed advances ratio at 4.5 %. The GNPAs of all SCBs sharply increased to
7.6% as of March 2016 compared to 4.6% in FY15. The restructured standard advances ratio
declined considerably to 3.9% as compared to 6.4% in FY15 for all SCBs. GNPAs largely
contributed to the increase in the overall stressed advance ratio to 11.5% for FY16 from 10.9 in
FY15. Looking at the y-o-y growth of GNPAs there has been a significant rise across public,
private and foreign sector banks in FY16. This is reflected in the sharp 79.7% increase in GNPAs
of SCBs during FY16.

The data of 2016 –17 has not yet been analysed completely. The working are still going on, but i
will tell you the position in the previous year.

Rs. 6,14,872 Crores is the NPA position of our public as well as private sector banks during the
demonetisation period which has increased around 53% from the last year 2015–16. Average %
level of Gross NPA for public as well as private sector banks is around 18–20%. Net NPAs are
around 11% of the total advances.

For the record kindly note the following – (all figures are as of December 2016)

Despite the Reserve Bank of India (RBI) announcing numerous restructuring schemes, the bad
loans have risen up from Rs 261,843cr by 135 per cent in last two years. They now constitute 11
per cent of of the gross advances of Public Sector Unit (PSU) banks. In all, the total NPAs
including both the public and private sector banks were Rs 697,409cr in December 2016. These
figures were compiled by Care Ratings.

Five banks have reported gross NPA ratios of over 15 per cent. Indian Overseas Bank’s (IOB)
gross NPA ratio reads 22.42 per cent, which means Rs 22.42 out of Rs 100 lent by the bank will
be classified as bad loan. Similarly, UCO bank posted NPA ratio of 17.18 per cent, United Bank
of India (UBI) read 15.98 per cent, IDBI bank read 15.16 per cent and Bank of Maharashtra read
15.08 per cent.

AQR covered 36 banks (including all PSBs) which accounted for 93 per cent of the SCBs’ gross
advances.

The major objectives of the AQR exercise were:

 To examine the assessment of asset quality at the bank level and at the system level as a
whole.

 To uniformly deal with cases of divergence in identifying NPAs/ additional provisioning

across banks.

 To ensure early finalisation and communication of divergences in provisioning giving banks

sufficient time to plan the additional provisioning requirements so that they can present clean
and fully provisioned balance sheets by March 2017
Proposed Course of Action –

The problem statement given in the case study explicitly focuses on the consolidation of the
PSBs. Hence the solution part of the case is focused on consolidation of PSB so as to tackle
NPA; hence we would like to propose following recommendations before the Ministry-

The recommendation in line with the given problem statement consist of two parts

1 to avoid growth of the NPA

2 to gain advantage to tackle the NPA through consolidated
As proposed in the problem statement, we have put up a strong case for consolidation and a
recommendation case to avoid the further enlargement of the NPA as mentioned in the point
number 1.

1 To avoid growth of the NPA –

All the focus till the date was on the recovery of the allotted loans by the banks. Till date, the
recovery processes through the all possible means have not produced the results strong enough to
be taken or considered as the concrete solution or the panacea for tackling the rising NPA
problem.

The major missing point till date was the lending pattern. For the corporate as well as the
consumer loans, the amounts of the loan are given mostly in direct payments and all at once. The
primary focus to do the same is to reduce the time window to turn a business into a net cash flow
positive entity and start obtaining the interest. As per our recommendation, this pattern of one
time allotting the entire amount of the loan has to be altered in composite manner. The loan
amount should be sanctioned all at once, but must be given in an systematic approach where the
peronnel with expertise (similar to IP) will decide that how much amount of the loan should be
given at time and thereafter with time intervals suggested by such experts, once the loan are
allotted in a systematic phased manner the possibility to address and detect any type of non-
performing or doubtful account rises and the action can be taken accordingly. None of the
lender or lending platform currently follows this approach. Although this system may be
complex to construct, but the chances to avoid the loss of money through this type of lending is
high.
((Examples needed))

2 The Great Indian Consolidation –

In 1998, a committee headed by M Narasimham had recommended a series of reforms needed to
strengthen the banking sector. Among them was a need to consolidate banks in a way to create a
handful of large national lender and a few strong regional lender. The committee had also
recommended handing over more decision making power to the banks and reducing push by
government. PJ Nayak Committee, which submitted its report in 2014, had noted that the
government needs a radically different approach towards state-owned lender if it hopes to reduce
the fiscal burden it incur due to the constant need to recapitalize these lender.

There are currently 19 PSBs in India excluding the 7 associates of the SBI and the IDBI.
Although the baking system is strong enough in India and the people shows adequate trust in
banks and nowhere the cases of the bank runs are reported, the problem of NPA has started to
influx the germs into the system. In comparison with the banking system of the other countries,
the Indian banks look stronger but the further consolidation is needed to meet the global
standards as per the Basel III norms before the end of next FY.

The government is pushing for consolidation among the state-run banks in order to help the
lender gain efficiency and scale, and operate without the support of repeated capital infusion to
bolster their balance sheets. The government is reported to be mulling creating six large public
sector banks of global scale, excluding the State Bank of India, also with an aim to help the
smaller banks with weaker balance sheets get support from the larger ones with strong finances.

The measures could include a combination of capital-raising from the market (similar to ETF),
dilution of government holdings (IDBI), additional capital infusion by the government
(Indradhanush scheme), sale of non-core assets, merger based on strategic fit. This strategic fit
would mean the consolidation of the banks based on following closely chosen factor –

1) Banks to be merged should cover same regions

2) asset quality of the entities to merged should be comparable
3) capital adequacy of the banks to be merged should be comparable
4) profits of the banks to be merged would also be considered.
1) amount of capital, CRAR
2) The credit agency, part of S&P Global, estimated that banks have provisioned for only
around 40% of their exposure to these assets.
3)
4)
If we look at the NPAs of the banking system, we can see that most of the NPAs are saturated
with the PSBs and hence, if system gets a shock they will be the firt to feel the shake. Hence it is
important that banks must be equipped with considerable capital and must have arms strong
enough to defend itself against the rising giant NPAs.

As per the latest news report published (no), the Indian banks are at all-time NPA amounting too
almost ₹ 6.14 lac cores. The graphical representation shows how the NPA are rising in last few
quarter. (Insert graph). Out of the all the NPA quoted and compiled the PSBs account for almost
% of the NPA (see image).

Alone SBI holds almost %; hence consolidation is needed to absorb the NPA so that without any
FPO, banks get sufficient capital for fighting the same. The gross NPAs of public sector lender
range from 7 % to 24 % across banks. IDBI Bank has the highest bad loan ratio of 24% while
Indian Bank has the lowest ratio of 7.2 %.

GNPAs largely contributed to the increase in the overall stressed advance ratio to 11.5% for
FY16 from 10.9 in FY15. Looking at the y-o-y growth of GNPAs there has been a significant
rise across public, private and foreign sector banks in FY16. This is reflected in the sharp 79.7%
increase in GNPAs of SCBs during FY16.

The data of 2016–17 has not yet been analysed completely.

r. 6, 14,872 Cores is the NPA position of our public as well as private sector banks during the
demonetisation period which has increased around 53% from the last year 2015–16. Average %
level of Gross NPA for public as well as private sector banks is around 18–20%. Net NPAs are
around 11% of the total advances.
For the record kindly note the following: - (all figures are as of December 2016)
Despite the Reserve Bank of India (RBI) announcing numerous restructuring schemes, the bad
loans have risen up from ₹ 261,843cr by 135 % in last two year. They now constitute 11 % of the
gross advances of Public Sector Unit (PSU) banks. In all, the total NPAs including both the
public and private sector banks were r 697,409cr in December 2016. These figures were
compiled by Care Ratings.
Five banks have reported gross NPA ratios of over 15 %. Indian Overeas Bank’s (IOB) gross
NPA ratio reads 22.42 %, which means ₹ 22.42 out of ₹ 100 lent by the bank will be classified as
bad loan. Similarly, UCO bank posted NPA ratio of 17.18 %, United Bank of India (UBI) read
15.98 %, IDBI bank read 15.16 % and Bank of Maharashtra read 15.08 %.

Hence we are recommending that the armada of almost 21 PSBs should be consolidated and
merged into a fleet of 7 large banks, one of the dreams for Indian banking system. We are
suggesting all the banks to be absorbed to form following 7 banks.

The Impacts Envisaged

Sectorial Analysis –

PSU banks are seeing a positive rerating by analysts with upgrades in earnings estimates across
the board on the back of improved operational parameters. The BSE Bankex has been steadily
rising in the last few weeks, powered by a revival in interest in public sector banks with the
valuation gap to private banks narrowing on improving operational parameters against a
backdrop of robust credit demand.

Public sector banks have historically traded at a significant discount to private banks because of
well-known issues including slower growth of core operations alongside over-reliance on trading
income, higher staff costs and regular management changes. Apart from these, the higher
provisioning costs from deteriorating portfolio quality and continued slippages from restructured
assets in the last year have compounded the issue with banks seen as unduly influenced by
government policy. However, in the current environment of stronger credit demand and with
increasing evidence of a thrust towards improved operations, the segment is seeing a strongly
positive rerating by analysts with upgrades in earnings estimates across the board.
The key factors expected to work to the advantage of public sector banks includes their presence
in the rural-semi-urban regions (between 40-60% of total branches) where the next wave of
demand growth is expected driven by a good monsoon and increased government spending on
rural programs. Operationally, a concentrated thrust on opening new ATMs and drive to expand
the low-cost CASA deposit base alongside improved use of technology has helped stem the loss
of market share in CASA deposits that the banks had seen a couple of years ago, according to a
Morgan Stanley report.

Net interest margins (NIMs) are expected to stay firm or even improve as banks have revised
their prime lending rates (PLR) upwards with the increase in deposit rates. This move surprised
the street while reinforcing the strength of the demand for credit.

The only prevalent concern is with regard to portfolio quality and higher credit costs from more
slippages from restructured loan portfolio into NPL (Non-Performing Loan) buckets. Morgan
Stanley raises this red flag particularly with regard to Canara bank and Corporation bank.
However, given the strong economic growth scenario, additional deterioration from current
levels seems unlikely, the report adds, with a global event leading to sudden block in corporate
lending emerging as the main risk.

Determinants of NPAs

As discussed earlier, NPA levels of banks have been influenced by several microeconomic as

well as macroeconomic factors. The independent variables used in the panel data analysis to

explain the NPA levels of banks are as follows:

a. CG (Credit Growth) represents the growth in total advances given by banks to

borrowers. This shows that banks are ready to take more risk for higher profits. A

one year lag is considered (CGi(t – 1)) assuming that a loan takes one year to turn bad.

Our hypothesis is that a growth in credit by banks following an aggressive credit

policy could lead to a growth in NPA. A counter-hypothesis could be that a period of

economic boom leads to greater demand for credit while having low risk of default.
b. PSA (Priority Sector Advances) represents the share of priority sector advances among

the total advances given out by a bank. Since the loans are given under special rules

to promote the growth of the economically backward section of the society, these

loans could be expected to perform sub-par. So an increase in priority sector loans

could increase the NPA levels of banks.

c. OE (Operating Inefficiency) represents the amount expended for each rupee earned.

The banks spending more money for their operation could have highly skilled employees

for credit appraisal, asset appraisal and loan monitoring processes, and thus could

have low NPA levels.

d. RD (Restructured Debt) represents the ratio of total restructured debt to the total

advances of a bank. The values are considered with a one year lag (RDi(t – 1)) assuming

that the loan takes one year to turn bad or revive completely. Mostly, restructuring of

an asset could revive it completely leading to reduction in the NPA levels.

e. ES (Advance to Sensitive Sector) represents the ratio of total advance to the sensitive

sector (comprising capital markets, real estate and commodity market) to the total

advances of the banks. The values are considered with a one year lag (ESi(t – 1))

assuming that loans to this sector could turn bad after a year. These sectors are very

volatile with a scope for drastic changes in their prices. Increased lending to such

sector could increase the NPA levels of the banks.

f. GDPG (GDP Growth) represents the growth rate of India’s GDP. A higher growth

rate would signify increased business activities and hence, better performance of the

loans given out by banks leading to a decline in NPA levels.

g. TRB (Trade Balance) represents the ratio of India’s trade balance (total exports –

total imports) to the GDP. Higher trade balance ratio signifies better performance by

exporters of the country and hence could be negatively correlated with NPA.

h. WPII (Wholesale Price Index Inflation) represents the inflation of the country
represented by the wholesale price index. Higher level of inflation would reduce the

Macroeconomic Factors Affecting the NPAs

in the Indian Banking System: An Empirical Assessment

65

disposable income of an individual/entity and would adversely impact his/her loan

repayment capability and hence would increase the NPA levels.

i. WALR (Weighted Average Lending Rate) represents the weighted average lending

rate of banks across sectors. An increase in the weighted average lending rate would

increase the burden on the borrowers and hence increase the chances of defaults.

j. FD (Fiscal Deficit) represents the ratio of the fiscal deficit to the GDP of the country.

Increase in fiscal deficit would lead to increased borrowing by the government which

is considered as a safe asset with no chances of default. This would also reduce the

money available for lending in the market and increase the weighted average lending

rate. Thus, an increase in fiscal deficit could reduce the NPA levels of banks. RBI

declares the Statutory Liquidity Ratio (SLR) which makes it mandatory for banks to

invest in government securities. Banks with surplus liquidity are also inclined to

invest in these securities, over and above their SLR, as they are considered a secured

investment option without any chances of default

Public Sector Banks

Results of the analysis of panel data of public sector banks have an explanatory power of 67.09% and
show that macroeconomic factors are the major determinants of the NPA ratios of the public sector banks
(Table 3). Keeping other parameters constant, a 1% rise in fiscal deficit ratio decreases the NPA ratio by
6.55%. Similarly, a 1% rise in the trade balance ratio and GDP growth leads to a 3.77% and 2.14% drop
in the NPA ratio, respectively. Lastly, a 1% growth in WPI inflation levels increases the NPA ratio by
0.9%. Among, the microeconomic factors, 1% growth in restructured debt leads to 1.61% rise in NPA
ratio, while a similar rise in credit growth, priority sector lending ratio and ratio of advances to sensitive
sector result in 0.29%, 0.56% and 0.57% fall in NPA ratio, respectively. A unit percent growth in
operating inefficiency increases NPA ratio by 0.77%. Weighted average lending rate has negligible
impact on the NPA ratio.