EFFECT OF NON-PERFORMING ASSETS ON OPERATIONAL

EFFICIENCY OF CENTRAL CO-OPERATIVE BANKS

Dr. Justin Nelson Michael *

Dr. G. Vasanthi **
Dr. R. Selvaraju **

Abstract

Credit risk stands out as the most detrimental risk to which Banking business

is exposed to. Co-operative banks which have proved to be vessels of rural

development and financial inclusion, have been susceptible to credit risk throughout

their history. The Prudential Norms of Income Recognition and Asset Classification

were implemented for Co-operative Banks in India in 1996-1997 in order to

strengthen them and improve their quality. Non-performing Assets (NPA) in the loan

portfolio affect the operational efficiency which in turn influences profitability,

liquidity and solvency position of co-operative banks. This is a theoretical analysis of

the effect of Non-performing Assets on the Operational Efficiency of Central Co-

operative Banks.

Key words: Co-operative Banks; Non-performing Assets (NPA); Operational

Efficiency

JEL Classification: G21, G32, E44, E51, M21,O16

* Corresponding Author
Kristu Jayanti College,
K. Narayanapura, Kothanur PO,
Bangalore – 560077.
Email: nelz.jm@gmail.com

** Professors in Commerce, Annamalai University

Electronic copy available at: http://ssrn.com/abstract=1735329

 EFFECT OF NON-PERFORMING ASSETS ON OPERATIONAL
EFFICIENCY OF CENTRAL CO-OPERATIVE BANKS

The financial health of co-operative banks is reflected by their operational

efficiency. Among other factors, Non-performing Assets (NPA) in the loan portfolio

affect the operational efficiency which in turn influences profitability, liquidity and

solvency position of co-operative banks. They have to maintain and increase viability

by generation of more products in order to meet capital adequacy norms and make

provision against NPA. A crisis in liquidity occurs when the funds deployed by the

banks get locked up as NPAs, which reduce the profitability and liquidity, indirectly

affect the solvency position of the banks. Now it is high time for co-operative banks

to monitor NPAs to strengthen their operational efficiency.

Banking business is exposed to various risks such as credit risk, liquidity risk,

interest risk, market risk, operational risk, and management risk. But, credit risk

stands out as the most detrimental of them all (Iyer, 1999). The risk of erosion in

asset value due to simple default or non-payment of dues by the borrowers is credit

risk or default risk (Sarma,1996). Credit risk is acute in Central Co-operative Banks

(CCBs), since they are the important vessels of priority sector lending, through their

member Primary Agricultual Co-operative Banks (PACBs).

Non-performing Assets (NPAs) are not a new development in banks today.

Since the dawn of banking business, banks and financial institutions have been facing

the problem of their loans and investments proving difficult in recovery and turning

out to be bad assets, where not only interest could not be recovered from the

borrowers but on numerous occasions even the principal had to be compromised or

written-off. The level of NPAs in the loan portfolio of banks is an evidence of their

Electronic copy available at: http://ssrn.com/abstract=1735329

exposure to credit risk. Default of credit leads to NPAs in the loan portfolio of the

banks. After the implementation of the prudential norms in 1996-1997, the level of

NPAs has been increasing in the CCBs. The gross NPAs of CCBs in Tamil Nadu had

been Rs. 113853.73 lakhs in 2002-2003 (TNSCB).

Effect of NPAs on operational efficiency

NPAs affect the economy both at the macro and micro levels. At the macro-

level, alarming degrees of NPAs have a detrimental effect on the macro-economy. A

high level of NPAs or loss, eliminating fully or partially the banks’ capital could

cause significant banking crisis or banking distress. Banking crisis exists in the

country if the level of NPAs touches 10 percent of GDP (Khan and Bishnoi, 2001).

Though the banking reforms spearheaded by the Narasimham Committee have been

proceeding in a phased manner in the country, the high level of NPAs poses a serious

hurdle for pushing through the reforms (Velayudham, 2001 ).

Effect on profitability

At the micro-level, NPAs jeopardize the financial position of the bank, the

borrowers and subsequently, the rural economy. Specifically, NPAs affect

profitability, liquidity, and solvency of the bank. Continuous decline in profitability

due to increase in NPAs would ultimately jeopardize the viability of the bank.

Mounting NPAs reduce the interest spread of the bank (Brahmananda, 1999). The

presence of NPAs in the bank balance sheet corrodes the average earnings from loan

assets and total assets (Toor, 1998). The interest spread, an indicator of the operating

profitability declines due to NPAs, since the interest income on NPAs cannot be

accrued due to prudential regulations and provision also has to be created for NPAs

from the operating profits. A large amount of managerial time and manpower would

have to be spent on monitoring the accounts in default, adding avoidable costs to

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transaction costs of lending operations, increasing the burden of the bank. Thus the

profit margin would be reduced further.

The presence of NPAs leads to increase in real interest rates (Roy, 2001). The

real interest rate (the difference between nominal rate of interest and the expected rate

of inflation, at a realistic level) has to be kept low so that borrowers do not pay a high

price and depositors have an incentive to save, as a measure of deregulation. But in

India, structural rigidities in the form of high intermediation costs and NPAs have

been responsible for higher real interest rates. The loss of income from NPAs not

only brings down the level of income of the banks but also hinders them from quoting

finer Prime Lending Rates (PLR) (Jain and Balachandran, 1997). Thus, the foremost

concern of banks is how best to reduce the share of NPAs to total advances but also

the level of NPAs, though they are familiar with non-payment risks.

Effect on liquidity

The loan portfolio with NPAs reduces the liquidity position of the credit

institution. Loans classified as NPAs affect the interest of both the borrowers and the

credit agency. When the resources deployed by the CCBs and PACBs are locked up

as NPAs and overdues respectively, the credit agencies are impaired from obtaining

refinance from the apex lending agencies. Their capacity to undertake fresh lending is

impaired, adding woe to the existing resource constraints (RBI, 1989). The lending

capacity of the banks is adversely affected due to their inability to recycle the

resources or to raise more resources from higher financing agencies. Any liquidity

crisis in co-operative banks will subsequently hinder capital formation in agriculture,

which will decelerate economic development (Georgekutty, 2000), since they play a

major role in rural lending.

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 Among various other aspects of performance of the

co-operative banks, recovery performance is the major eligibility criterion for co-

operatives to obtain refinance from the apex bank. However, NPAs impair their

capacity to obtain refinance. Recoveries also serve as an indicator of the quality of

lending since repayments are expected from out of the incremental income generated

by the productive use of loans. The increase in the quantum of NPAs would outdo

the actual expansion of credit in real money terms (Chari and Narasimham, 2002).

As a defaulter, the borrower is cut-off from any access to credit from

institutions. The borrower’s productive enterprise is affected. A much higher price

has to be paid for any informal source of credit. Thus, the agriculturist and other

related enterprises suffer on account of non-availability of adequate credit supply for

investment and working capital.

Effect on solvency

Decline in the profitability and liquidity ultimately affects the solvency

position of the co-operative banks. In the three-tier structure, the central bank is

responsible for curbing the overdues at the primary level. The statutory and non-

statutory powers in respect of supervision and control over the societies and the

leadership along with local standing and knowledge of local conditions are expected

to help in prompt recovery of loans. The central banks are indeed best suited to

supervise and control the societies, ensuring among other things prompt recovery of

loans from the latter (RBI, 1954).

One of the important limitations of the federal character of co-operative credit

structure is that the working of primary societies undermines the capacity of the

organization at the immediate higher level to work actively (Rao MK 130). This

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problem is manifested more in the field of short-term co-operative

credit. Heavy overdues at the primary level turn the societies dormant, creating a

difficult situation for central banks to channel fresh credit (Puyalvanan, 1998). The

NPA level in the CCBs increases simultaneously. Hence, it is imperative to curb

overdues at the primary level. Delinquency of co-operative credit is due to default,

both non-willful and willful. However, willful default is identified as the main reason

for mounting overdues. (RBI, 1981)

Need for effective recovery strategy

The CCBs play a significant role in the economy. Though the vital credit

disbursed by them increases over the years, their effect has been dampened by the

increase in gross NPAs. Quantum increase in various classes of NPAs, sub-standard,

doubtful, and loss assets deplete asset quality. Not only liquidity and profitability

decline but also the solvency of the banks is at stake. Delinquency of credit in PACBs

contributes to NPAs in CCBs. The expectation of waiver, coupled with the callous

attitude of the borrowers is the main deterrent to repayment. The attitude of the

government inhibiting the use of coercive methods of recovery has accelerated wilful

default. The various relief and one time settlement schemes have enabled marginal

recovery of NPAs. Recovery through litigation is rather slow, since the number of

executions pending are mounting in all the banks. Thus various other avenues of

recovery, especially compromise settlements may be considered. However, effective

credit monitoring cannot be pushed to the background. Only prompt, preventive and

curative measures can curb the menace of NPAs.

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