Banking & Research VII - NPAs in Indian Banks

Professor Ghoshal had immense faith in the ability of Indian corporates to compete in global markets. As if to catch up with his prophecy, there is a lot of ‘new found confidence’ on display among the Indian companies. They have mustered enough strength to take on globalization confidently. The rising demand for consumer credit from banking sector is a sure pointer towards the growing demand in the country for industrial output. The corporates are even resorting to financial engineering: Companies are today enthusiastically moving forward to cash in on the prevailing historically low interest rates by borrowing afresh to retire high cost old loans. They are gung-ho on restructuring their debt portfolios with a mix of foreign currency and rupee-denominated loans so as to reduce capital cost and stay competitive in the market. 

Amidst the “feel good” atmosphere we also have a distressing phenomenon demanding explanation from the nation as a whole. Recently, the Reserve Bank of India gave a stern warning to banks against attempt to “evergreen” their balance sheets for the current financial year ending March 31, 2004. The RBI’s warning is directed against the Non-Performing Assets (NPAs) of banks that have become a nightmare for bank managements. Reserve Bank wants banks to rightly classify assets as bad debts instead of trying to camouflage the balance sheets.

But, the real tragedy behind the whole episode is that no one is willing to look at the root cause of the NPAs. It is the failure of the businesses to generate the anticipated cash flows as projected at the time of committing fresh investment either for expansion of existing line of business or creation of new capacities, to service the debt. There are multiple reasons for such failures: Lack of entrepreneurship at the top in executing the project as envisaged; undertaking ambitious projects all in the anxiety of garnering the early bird advantage or to prevent others from entering the competition that too with no matching owned-funds or internal accruals to realize the projected sales volume; unanticipated liquidity crisis owing to either non-receipt of own-funds in time or hiccups in the release of loan by banks; blatant misuse of funds meant for execution of the project; deliberate default in repaying the debt and so on.

There could also be instances where banks and financial institutions might have themselves contributed their mite, though unwittingly, towards NPA’s accretion. They might not have displayed matching skills to assess the multivariate projects that have sought finances effectively, allowing the embedded risks to creep into their balance sheets as NPAs. Or, it could be that banks have not exhibited the requisite resilience in locating the incipient weaknesses of projects well in time and initiate appropriate action in terms of restructuring the debt etc., that could have seen the project through with a little or no damage to the core.

It is in fitness of things that we must also examine the role of “character” of all those involved in the episode. Be it individuals or corporates, all live with reference to their “character.” It is the character that defines the fate of a person or a corporate. It is the character of a corporate which encourages unchecked greed for wealth resulting in irrational expansion of existing lines of activities or diversion into an altogether new line of business, with no matching intrinsic strength. Such irrational commitment of investments to fresh projects coupled with lack of ‘sincerity of purpose’ obviously leads to failure in accomplishing the envisaged business objectives. It is the very character of the company that drives it either to deliberately misuse the cash flows or willfully default from repaying the debt. In the final analysis, it is the “character” of the corporates that defines the level of NPAs in banks and the subsequent need for “evergreening” of banks.

As seen above, the vexatious problem of NPAs has been defying solution. Against this backdrop, the article “Effective Management of NPAs” by T V Gopalakrishnan, has taken an altogether different approach to find a solution to management of NPAs. The model developed in the article suggests the creation of a “Precautionary Margin Reserve” (PMR) @ 0.10% for category A; 0.25% for category B; 0.50% for category C and 0.75% for category D loans. This automatically strengthens the balance sheets of banks. Such accretion of strength automatically establishes credibility.

This is followed by the article titled  “Banking Sector Reforms: An Impact Analysis” by Amita S Kantawala, which examines the impact of the reforms on credit deposit ratio, credit GDP ratio, investment in government securities to deposits, and the findings reveal a significantly lower interest income to total assets ratio and other income to total asset ratio among nationalized banks.

The competitiveness of Indian commercial banks, in a deregulated market scenario during the period 1996-2002, has been examined in the article titled “Banking Sector Liberalization and Efficiency of Indian Banks” by A Amarender Reddy  by using the statistical tool data envelopment analysis and window analysis. The main findings indicate that there is an increase in technical efficiency and scale efficiency of most of the banks in deregulated period. Most of the foreign banks exhibited most productive scale size while most of the public sector banks are working under decreasing returns to scale. Capital adequacy ratio was found negatively influencing the scale efficiency while its influence on pure technical efficiency was positive.

The last article titled  “Market Microstructure Effects of the Transparency of Indian Banks” by Niranjan Chipalkatti, investigates whether enhanced transparency imposed on Indian banks under the reforms launched is indeed rewarded with increased market liquidity by way of reduced bid-ask spreads. The results reveal that the enhanced transparency depicted by the Indian banks had no significant impact on the market liquidity of private sector banks, while in the case of public sector banks, the enhanced transparency reduced their market liquidity. The paper ultimately suggests that public sector banks should strengthen their corporate governance and risk management practices.

All this suggest that banks have to change their hardware as well as software to catch up with the demands from the changing market dynamics. In the words of Prof. Ghoshal, these organizations need to make some radical, even transformational changes to their well embedded organizational and management models—something akin to a caterpillar transforming itself into a butterfly.

-- IJBM Vol. 3. No.2