Alender loses money when a borrower stops paying interest or repaying the principal on the loan. Such a loan is known as Non-Performing Asset (NPA). The loans given by a bank are its assets. Any loan which ceases giving a return to its lender for a specified period is known as an NPA. Generally, that specified time is 90 days but may vary with countries and instruments. India’s banking industry is seriously afflicted by huge amount of NPA. Our discussion here is on how severe India’s NPA problem is.

First, let’s look at the big picture. In India, nearly Rs. 10 lakh crore worth of loans are NPAs. This is a massive sum and translates to more than 10 per cent of all loans given. When restructured and unrecognized NPAs are added, the total stress would be around 22-25 per cent of total loans. No banking system can take such big hits and is bound to face troubled times.

The prime reasons for NPAs are economic slowdown, flawed credit appraisal process, inadequate post disbursal monitoring, diversion of funds by promoters and consequential frauds, improper valuations of tangible and intangible securities, delayed reporting of frauds, rampant corruption, political and bureaucratic intervention in grant of loans and the wait and watch approach by banks. Besides fear of the three Cs, courts, CBI and CAG, the operational factors cited earlier have their own role in timing of NPAs recognition.

High NPAs have adversely affected the decision-making for fresh credit sanction and its disbursal. An increasing amount of bad loans have prompted banks to be extra cautious, which has dried up the credit channel and in turn adversely affected the economic activity in the country which has been further severely hit by Covid 19. World economies, and India cannot be an exception, are reeling under Covid-19 impact. Most of the businesses, particularly tourism, hospitality, amusement parks, theatres, auto industry, aviation etc. have been severely hit and large number of units face closures. Revival of business calls for expeditious disposal of credit proposals. But for fear of business decisions being subjected to subsequent scrutiny, bankers are shying away from taking decisions.

Two components are vital in resolving NPA: the immediate task of determining the banks’ current accumulation and the more critical long-term task of ensuring that NPAs do not accumulate again to this extent.

The principal factor for accumulating bad loans in the Indian banking system is exaggerated economic growth expectations and over-ambitious projections erroneously or otherwise accepted by lending institutions. This makes the bank disburse credit left, right, and centre. If the high expectations do not materialise, bad loans accumulate. When an economy experiences healthy GDP growth, a substantial part of it is financed by the banking system’s credit. If the GDP keeps growing, the repayment schedule does not get affected.

However, when the GDP growth slows down, the bad loans increase due to a host of macroeconomic factors, primary among these are interest rates, inflation, unemployment rates, and changes in exchange rates. At times Indian banking industry failed to appreciate genuine concerns of borrowers in time and it accentuated the problem. This is particularly true in case of credit needs of MSMEs.

Bank-related micro indicators such as appraisal and monitoring skills of bank staff, adoption of technology, appreciation of borrower’s genuine needs, size of the bank, pricing of loans, decision making with regard to restructuring and settlement proposals, risks identification and mitigation measures taken, long term strategy and capital adequacy also contribute to accumulation of bad loans. Credit policy and the “herd behaviour” of banks similarly plays a role in the growth of NPAs.

The recent jump in NPAs can be attributed to the transparency pressures imposed by the Reserve Bank of India (RBI). Indian commercial banks had been underreporting NPAs by way of interbank transactions resulting in helping each other to show a healthier position and employed other methods ~ restructuring or rolling over existing loans ~ to make their balance sheets look cleaner than they were. Admission of NPAs compels banks to make capital provisioning for those bad loans, reducing their profits. Therefore, official NPA figures on the banks’ balance sheets may not represent the problem’s actual extent.

The trends in the growth rates of Gross NPAs (GNPA) and GDP show that bad loans tend to grow with a lag in GDP growth rates. This implies that once the GDP growth rate rises, the Indian banking system is likely to extend more credit, and roughly after two to three years of profitable growth once economic activity slows down, bad loans start showing up.

The massive jump in the quantum of NPAs made the bad loans more sensitive to the growth in GDP, which has reduced the time lag between the growth rates in NPA and GDP. The accumulated bad loans made banks apprehensive about extending loans liberally. Thus, any small fall in the GDP growth rate elicits a lot of caution, leading to decreased disbursal of bank credit, which in turn slows down the GNPA growth rate. As lending rates increase, NPAs tend to increase due to further pressure on repayment commitments and vice versa.

In India, priority sector lending is often cited as a significant reason for the accumulation of NPAs. This is not true. Accumulated NPAs in the priority sector are relatively small compared to the accumulated NPAs in the non-priority sector. In recent times the infrastructure sector has contributed significantly to the kitty of stressed assets.

Economic revival is not possible unless GDP growth is accompanied by a sizeable increase in employment. Jobless growth will not create adequate purchasing power in the hands of the ordinary consumer. Without more purchasing power, no economic development can sustain in the long run. It has a domino effect in short.

The origins of India’s NPA problem lie in decisions taken during the early-2000s. During that period, India’s GDP growth was surging to 9-10 per cent per annum. For the first time in India, everything was going right. Corporate profitability was amongst the highest globally; it encouraged firms to hire labour aggressively, which sent wages soaring. Firms launched new projects worth lakhs of crores, particularly in infrastructure-related areas such as power generation, steel, and telecom, setting off the most significant boom ever ~ an astonishingly upbeat credit regime financed this investment.

However suddenly, things started to go wrong towards the end of that decade. The firms’ costs soared far above their budgeted levels, as securing land and environmental clearances proved difficult and time-consuming. As if these problems were not enough, borrowing costs increased sharply. This is also the period when the banks lent throwing caution to the winds for various reasons. This led to a lot of scams both within and outside the banking industry. Notably it was when Raghuram Rajan was Governor of RBI that Asset Quality Review was undertaken in the banking industry, which to a large extent revealed the real magnitude and dimensions of NPAs.

Let’s shift our focus to the impact of NPAs. Lenders suffer a lowering of profit margins. Stress in the banking sector causes less money to be available to fund other projects, and therefore, there is a negative impact on the national economy. Banks begin to charge higher interest rates to maintain profit margins. As investments get stuck, unemployment begins. Investors do not get rightful returns. And with the trigger of this vicious circle, the biggest casualty is the economy. The rest is common sense.

As it is, the last quarter of the previous financial year registered an abysmally low rate of GDP growth i.e. 3.1 per cent which got worse due to adverse impact of Covid. For the economy to bounce back many measures are being contemplated, few of these are already operational. Nevertheless, notwithstanding the pandemic, NPA remains a major area of concern and the quotient has only been amplified with negative earnings and growths.

It is increasingly evident that an innovative and flexible approach is needed for each affected bank to apply on a case-by-case basis. Only then will is a possibility that the country may get out of this financial mess. Successive governments and RBI have come up with various measures but unfortunately these have proven to be inadequate to tackle the monster of NPA. Besides the introduction of Insolvency and Bankruptcy Code, the authorities are toying with the idea of formation of a Bad Bank. However even that concept is fraught with danger. But that is a narrative for another day.

The writers are chartered accountants