Severity Of The NPA Crisis In India

To understand the extent of the non-performing asset problem in the Indian banking sector and to come up with solutions, it is important to have a good measure of the problem. While the standard measures have their uses, they do not answer the question that everyone seems interested in: how severe is the NPA crisis? A new measure can be proposed- the ratio of the NPA to the bank capital. This measure shows that the crisis is already there but it also represents the severity of the crisis.

There are two metrics that are used to assess the scale of the problem. These two measure are – ratio of NPA (Gross or Net) to GDP and ratio of NPA to total loans.

NPA to GDP ratio measures the potential losses in relation to the size of the economy. This ratio is useful in cross country comparisons, given that countries are at different levels of GDP. The problem with this ratio is that it does not indicate whether banks are able to handle the NPAs with their own resources- their capital.

A more commonly used metric is the NPA to loans ratio. This shows the fraction of bank loans that have turned bad. One limitation of this measure is that it suggests the problem can be solved through loan management—growing the loan books of banks to make the NPA ratio smaller. This approach is not a reliable one. It depends on the overall economic environment and on the demand for credit. It assumes that the source of the NPA problem is external to the banking system and not in the weaknesses of the lending processes. If the demand for credit is low it becomes difficult for the banks to grow their loan books. Even if the demand for credit was high, it would be difficult for the NPA-ridden banks to grow. Prolonged NPA episodes destroy banks’ capital and constrain their ability to grow their loan books.

A high level of NPAs in the banking sector need not necessarily create a crisis situation, if the banks have the capital needed for provision for the losses. Bank capital is also a key factor in resolving the banking crisis. Hence, banks’ ability to withstand NPAs is best measured in relation to capital.

To understand the importance of the NPA to capital ratio, we compare the depth of the NPA problem across two banking crises in India. The banking sector had faced a NPA crisis in the mid-to-late 1990s. The surge in bank NPAs at that time took place in the aftermath of the introduction of robust income recognition and asset classification norms which exposed two decades of bad loans.

The NPA to loans ratio suggests that the current crisis is considerably less severe than that of the late 1990s. However, when NPAs are measured in relation to bank capital, the current crisis looks just as bad. In particular, the deterioration in the balance sheets of banks post-2010 is much sharper when measured using the NPA to capital ratio.

The drop in the NPA to capital ratios in 2016 looks hopeful but this is partly due to the additional capital received by many public sector banks as part of the government’s Indradhanush programme. Also, in light of the revised disclosures of NPA levels by some large private sector banks, the future ratios are likely to be much worse.

The comparison of the Growth rates of NPAs, Capital and Loans across the two crises is given as follows:


This shows that during the last NPA crisis, bank capital grew at a higher rate than NPAs. While the NPA to loans ratio was higher then, banks were not undercapitalized. They had a better ability to withstand the problem. In the current crisis, however, the growth rate of NPAs has been considerably higher than that of bank capital, further underscoring the severity of the crisis. The growth rates of bank loans on the other hand, have been similar across both crisis episodes.

The emphasis on the alternative measure of the NPA problem also highlights the importance of capital in resolving the crisis. If the NPA to capital ratio is to be restored to a level that was prevalent during the high growth years of 2003-2007, the capital base has to roughly quadruple. This is unlikely to happen through retained profits or sale of real estate or other similar strategies.

An attempt to revive the banking sector must include a credible commitment of capital for it to be meaningful. In the absence of capital and accompanying structural reforms, any solution will be incomplete and the banking sector may remain stagnant for a long time to come.

By Humneet KAUR

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