An Indian express report suggest that Public Sector Banks have written off huge sums of money from their balance sheet. It paints alarming picture of banking sector in India. Governor Rajan has suggested that mere band aid won’t do, deep surgery is required to nurse banking system to health.

What’s the problem with the banking sector in India? Why are banks writing off such huge sums and what kind of surgery is governor Rajan prescribing? In this write up, we shall try to answer all these queries but first some basics of banking.

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A bank is a financial intermediary that connects savers (depositors, creditors) with borrowers. People deposit their money in the bank for which they get paid some interest rate. Deposit amount on bank balance sheet (account book) is put under liability category for banks have to pay that amount back with interest.

Banks in turn lend that money to businesses and earn interest on it. Lent money is put under asset category as it generate income for the bank in the form of interest.

Banks also have something called capital or equity which is brought in by promoters/ investors. The capital is to absorb losses if borrowers default on their commitment and do not pay back their loans.

In summary, every banks has on its books, capital to absorb losses, assets which generate income and liabilities i.e. deposit amounts which have to be returned back with interest.

What’s Provisioning?

Whenever banks lend to any business, it carries with it some risk that money wouldn’t be paid back, borrower would dimply default. This risk is accounted for at the time of disbursal of loan itself in the form of keeping aside some capital in anticipation of future losses. This is called provisioning.

For instance, if banks feel 1% of loans are likely to default, they will provision 1% against any loans they make, When a loan actually defaults, they don’t have to book huge loss for they have it already covered. Note that higher the likelihood of default, higher the amount of provisioning. Guidelines in this regard are prescribed by RBI.

What is a non performing asset (NPA)?

Asset is one which generates income for the bank in the form of interest. Assets are meant to perform function of generating cash flows for banks. When assets cease to perform that function i.e. do not pay back interest and installments, they become non performing and are known as non performing assets.

Technical definition:  A non performing asset (NPA) is a loan or advance for which the principal or interest payment remained overdue for a period of 90 days.

Banks are required to classify NPAs further into Substandard, Doubtful and Loss assets.

1. Substandard assets: Assets which has remained NPA for a period less than or equal to 12 months.

2. Doubtful assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months.

3. Loss assets: As per RBI, “Loss asset is considered uncollectible and of such little value that its continuance as a bankable asset is not warranted, although there may be some salvage or recovery value.”

Let’s understand all this with an example: 

Suppose, SBI lent 100 rs to Mallya on 1st Jan 2015 which he has to return in 10 monthly installments of 12 rs each beginning 1st jan 2016.

Mallya returns 1st and 2nd installments on 1st jan and 1st feb 2016 but does not return 3rd installment on 1st march. He simply refuses to pay back.

Till 1st march 2016, this asst would be considered a standard asset as it was generating regular cash flows.

• After 90 days from due date i.e. 1st june (1st March due date), it becomes an NPA.
• From 1st june 2016 to 1st June 2017, it remains a substandard asset.
• After 1st june 2017 it becomes a doubtful asset.

When bank or auditors feel it’s virtually unrecoverable, it is termed as loss asset and after that it is taken off balance sheet in what is termed as writing off.

Why wouldn’t banks want to declare bad loans as NPA?

As NPAs carry higher risk of eventual default, provisioning for NPAs is higher than standard assets. They carry 15% provisioning. What this means is that banks have to set aside 15 rs to cover future losses, the same money they could have lent to someone else and earn interest on it. It basically brings down profitability of banks and erode their capital base.

But isn’t it like extending problem to the future?

Well, banks feel if they can continue lending to these assets so that they could repay interest (refinancing), some day economy will return and they will be able to repay all the debt. so they simply restructure the loan and keep these assets as standard assets. Rajan calls it policy of extending and pretending i.e. extending the loan and pretending as if everything’s alright even though there are serious underlying problems. This is what Rajan calls applying band aid.

Total stressed assets = Gross NPAs + Restructured assets

It’s true that some sectors are affected by economic downturn and would revive once economic cycle picks up speed but extending every loan for a long time creates problem of moral hazard and promoters simply lose interest in reviving the project for interest cost becomes too high with the rising debt. Banks keep on throwing good money after bad, day of reckoning eventually arrives when banks are forced to book huge losses and tax payers suffer.

In PSBs, restructured assets are more than double of NPAs and analysts feel restructured assets to be as bad as NPAs.

The other thing banks can do is recognize NPA as NPA and try to put project back on track. This would then lead to active intervention on the part of all parties concerned. Banks would take some hit on their balance sheet, write off some part, promoters will bring more equity, govt will provide clearances, tarriff authority can increase the tariff etc.

What are all the things that banks can do?

1. If management is inefficient, banks can change the management.
2. Acquire majority stakes under strategic debt restructuring (SDR) and sell the asset to new promoters.
3. Start liquidation proceedings if turnaround seems unlikely under SARFAESI act.
4. Sell asset to Asset Reconstruction Companies (ARCs).

This is what Rajan calls deep surgery but it would require recognizing the problem as NPA first. It would put strain on the profitability in the short run but cleaned up balance sheets would reflect true picture of the state of banks. Government will infuse capital in the banks so that banks are ready to lend money to deserving businesses which will lead to economic recovery as well as expand asset base.

Economic recovery will help stressed assets to pay back their loans while expanded asset base will increase denominator bringing NPA ratio down thus starting a virtuous cycle.

Gross NPA ratio = Total NPA/ Total asset base

We can decrease NPA ratio by increasing the denominator i.e. lending more.

A few more points:

Banks lend against capital and Basal committee on banking supervision prescribes norms for capital adequacy.

Capital Adequacy Ratio (CAR) = Total Capital/ Total risk weighted assets

This ratio has to be maintained for soundness of banking system. It’s clear from the above that to expand asset base, banks need more capital and for PSBs government has to infuse more capital.

PS– This article is to be read alongside this discussion to know the causes and ways of resolution of this mess.

Read this analysis of RSTV