Recognising that “asset quality of banks reflects the efficacy of banks’ credit risk management and the recovery environment”, the latest RBI report on ‘Trend and Progress of Banking in India (2011-12)’ paints a grim picture on the constitution and trend of asset quality confronting Indian banks.

Based on annual accounts and off-site data, the report highlights deterioration in all key diagnostics, that is, gross NPA (non-performing assets), net NPA and slippage ratios (fresh gross NPAs as a fraction of opening gross standard advances).

Public sector banks’ gross NPA ratio alone rose by 90 basis points in the last fiscal. This was partially offset by improved performance by foreign and private sector banks, resulting in an overall deterioration of 60 basis points for the commercial banking system as a whole.

Furthermore, fiscal 2011-12 has seen the slowest rate of growth in aggregate loans and advances at 17.4 per cent against 22.3 per cent in 2010-11 and 19.6 per cent in 2009-10.

In fact, the five year trajectory of growth in gross advances and gross NPAs reveals a widening adverse gap. These developments are increasingly worrisome, given continued macro headwinds, impending Basel III capital requirements and an already constrained fiscal position.

The RBI has clearly indicated that asset quality deterioration is a “default line” and the banking system should not rely on “misplaced comfort” in this regard.

Contrary to public perception, the pronounced deterioration in asset quality of public sector banks is driven by the non-priority sector. In 2011-12, this sector’s share in NPAs jumped from 48 per cent to 53 per cent, while the contribution of the agricultural, SME and other priority sectors has remained stagnant or marginally dipped.

Driving factors

The cyclical factors pertain to the prolonged domestic slowdown coupled with global recessionary conditions. The structural and institutional factors emanate from lack of adequate due diligence in credit appraisal during the boom period of 2003-07, institutional rigidities relating to debt recovery and post sanction loan monitoring.

What is not directly quantifiable is how much of the jump in the current gross NPA ratio is driven by the “one-time” dispensation announced in 2008-09 whereby banks were allowed to restructure sub-standard assets and report them as standard.

While this helped banks report better than actual gross NPA ratios in 2008-09 and 2009-10, in the hope of buying time, the prolonged slowdown may well be contributing now to an acceleration in NPA conversion from the dispensation bucket. Two ominous data points are evident from the report.

First, the ratio of restructured to gross advances is at a five-year post-Lehman high of 5 per cent for the system as a whole. This ratio has significantly deteriorated for non SBI nationalised banks and has jumped 250 basis points in the last one year. It is now perched at a long term high of 6.9 per cent. Second, the slippage ratio is also at a five-year high of 2.5 per cent.

It may be recalled that in the 2010-11 report, the RBI estimated that with a 25 per cent conversion rate to NPAs from the 2008-09 dispensation bucket, the gross NPA ratio for the commercial banking system would have hit 3.01 per cent by March 2011 (as against the then reported GNPA of 2.5 per cent). A year later, as at March 2012, we are now at 3.10 per cent. In the absence of disaggregated data, one can only speculate.

Policy Options

The concern is that new accruals to NPAs have been faster than reduction in existing NPAs due to lower levels of up-gradation and recoveries. This is in fact a vicious cycle which has the potential to accelerate systemic risk.

The RBI recognises the need for “countercyclical prudential regulatory policy and further strengthening by basing it on more systematic and rule-based footing.” A few policy options are in order.

First, tighter credit risk standards, robust surveillance and post sanction monitoring of bank lending to mitigate further adverse effects are an immediate necessity.

Second, close monitoring of net NPA ratios to ensure there is no let-up on provisioning. Both these options require significant policy and political will in the near term.

Third, implementation of dynamic loan loss provisioning in line with global approaches to stabilising the financial system merits serious consideration. This would mean a calibrated move towards a formal system of counter-cyclical provisioning in India, based on expected long period credit losses.

However, the success of such a system depends on reliability of accounting data, robust disaggregated loan loss history and an ability to get cyclical projections right. While each of these is important in itself, this last factor could yet prove to be the Achilles heel.

Already, worldwide, subjective assessments on the duration and depth of cyclical downturns are being challenged to the hilt. Considerable thought will need to be invested to ensure that models allow for sufficiently higher provisioning during cyclical upturns, which in turn, match actual NPA levels as closely as possible, in a prolonged and vicious downturn, such as the one we face now. We have the benefit of recent experience to learn from.

A recent IMF working paper on ‘Bank Asset Quality in Emerging Markets’ finds strong linkages between macroeconomic aggregates such as growth slowdown, weaker terms of trade and rapid credit growth on the one hand, and higher NPA levels on the other. This is intuitive and easy to understand. What is worrying however is the finding that “economic growth falls significantly after structural shocks that drive non-performing loans higher or generate a credit contraction.” This is the feedback loop from the financial sector to the real sector. Given the recent debate on the true state of asset quality in the Indian banking system, urgent measures are required to ensure that India stays the course in the run-up to Basel III implementation.

The authors are professors at S. P. Jain Institute of Management and Research, Mumbai.

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