Impact of NPA on Credit Growth AND GDP

Non Performing Assets  Impact on Bank Balance Sheet

NSN REDDY, AGM, Andhra Bank

Email id: nsn6507@yahoo.com

Around the world, finance is an important common thread which brings many sectors together and acts as catalyst for economic development of the country. The role of banking sector in economic transformation is significant as banks play vital role in providing the desired financial resources to the needy sectors. Banks lubricate the wheels of the real economy and are the conduits of monetary policy transmission and constitute the economy’s payment and settlement system. Thus, Banking is considered as backbone of the economy. In emerging economies, banks are more than mere agents of financial intermediation and carry the additional responsibility of achieving the government’s social agenda also.

Economic Development - Role of Bank Credit

The growth of the banking industry is closely linked with the growth of the overall economy. India is one of the fastest growing economies in the world and is set to remain on that path for many years to come. This will be backed by the stellar growth in infrastructure, industry, services and agriculture. In the above backdrop, banks have been extending credit flow to various sectors with focus on corporate sector during the last decade. The year-wise growth rates of GDP of the country and Banks’ credit are furnished in Table-1.

Table - 1 GDP Vs. Credit Growth (%)
Year	GDP	Credit
2004-05	7.0	30.9
2005-06	9.5	30.8
2006-07	9.6	28.1
2007-08	9.3	22.3
2008-09	6.7	17.5
2009-10	8.4	16.9
2010-11	8.4	21.5
2011-12	6.5	17.0
2012-13	4.8	15.1
Source: RBI Reports

The growth rate of GDP and credit growth of banks are in sync over the years which demonstrates the fact that there are ample opportunities for the banks to expand credit portfolio further in the ensuing years. Nevertheless, the survival and growth of the banks crucially depend on the size of the balance sheet as well as asset quality since the assets are the major source of income and life-line for the banks.

Indian Banking – Prudential Norms

The growth story of Indian Banking industry is quite interesting and fascinating both in terms of extensive branch network spread across the country and wide range of services to the clientele over the years. The post reform era has brought many changes in accounting standards like introduction Asset Classification and Income Recognition.

The policy of income recognition is based on the “record of recovery”. Income from NPAs is not recognized on accrual basis but is booked as income only when it is actually received.  Once account is classified as NPA, the unrealized interest that was taken to P&L account on accrual basis shall be reversed. Though, these concepts through many challenges to the banks in the initial years but enabled the banks to have healthier balance sheets which is the need of the hour.

An asset is classified as Non Performing Assets (NPA), if due in the form of principal and interest are not paid by the borrower for a period of 90 days. If any credit facility granted becomes non-performing, then the bank will have to treat all the credit facilities granted to that borrower as non-performing without having any regard to the fact that there may still exists certain credit facilities having performing status. As per the guidelines, banks are required to classify non-performing assets into three categories based on the period for which the asset has remained nonperforming and the realisability of the dues: 

i) Sub-standard Assets:  A substandard asset would be one, which has remained NPA for a period less than or equal to 12 months.  It indicates credit weakness and scope for loss if deficiencies are not corrected. These assets attract provisioning in the range of 15% to 25% of outstanding liabilities depending on realisability of securities available to the bank.

ii) Doubtful Assets: An asset would be classified as doubtful if it has remained in the substandard category for a period of 12 months. These assets carry higher provisioning compared to substandard assets which ranges from 25% to 100% depending on the security available and age of the asset remained under doubtful category.

iii) Loss Assets: A loss asset is one where loss has been identified by the bank or internal or external auditors or the RBI inspection but the amount has not been written off wholly. It is considered as uncollectible and warranted to continue as bankable asset since there is little scope for salvage or recovery value. It attracts 100% provisioning.

The reforms focused on modification in the policy framework, improvement in financial health through introduction of various prudential norms and creation of a competitive environment. The reforms carried out so far have made the balance sheets of banks look healthier and helped them to move towards achieving global benchmarks in terms of prudential norms and best practices.

Asset Quality – Evolution of NPAs

Management of asset quality has emerged as one of the major challenges facing banks today as it is the most important factor for the basic viability of the banking system. High level of NPAs not only affects core performance area of the banking system but also raises corporate governance issues. The trends in NPAs since 2007 are furnished in Table-2.

Table 2 - Evolution of NPAs
Year	Gross NPA (%)	Net NPA (%)
2006-07	2.5	1.0
2007-08	2.3	1.0
2008-09	2.3	1.1
2009-10	2.4	1.1
2010-11	2.4	1.0
2011-12	2.9	1.3
2012-13	3.4	1.4
Source: RBI Reports

The strong credit growth is the synonymous with improvement in asset quality and at the same time the declining credit growth in the system is an indication for asset deterioration and likely to add impaired assets further.  Asset Quality concerns persist as the growth in NPAs accelerated and continued to outpace credit growth.

The Gross NPA ratio of the banks has witnessed sharp increase from 2.90% as on 31st March 2012 to 3.40% as at end of March 2013. Similarly, the Net NPA ratio has gone up from 1.30% to 1.40% during the same period. The sectoral NPA for the year March 2013 is furnished in Table no.3.

Table 3 - Sectoral NPA as on 31st March 2013
No	Sector	Percent
1	Agriculture	4.7
2	Construction	4.0
3	Cement	2.7
4	Infrastructure	1.5
5	Iron & Steel	4.0
6	Engineering	3.7
7	Automobile	1.8
Source: Financial Stability Report June`13

Among the selected seven sectors, Agriculture, Construction, Iron & Steel and Engineering sectors registered highest NPA compared to other sectors. The low level of NPA under infrastructure sector can be attributed to increased incidence of shifting of infra advances to restructured portfolio. If the present trend is not addressed, this sector is likely to witness higher slippage ratio in the ensuing years.

Restructured portfolio

Global economic meltdown has affected almost all countries and our country is not insulated, either. However, India’s cautious approach towards reforms has saved it from possibly disastrous implications. Nonetheless, the truth is that our economy is also facing a kind of slowdown in Agriculture, Manufacture and Service sectors with a lag effect.

To support the ailing sectors, banks are undertaking restructuring of advances through relief measures such as reduction of interest rate, extension of repaymentschedule etc., to make them viable and bring back to normalcy. However, the Restructured portfolio is another major contributor for rise of NPAs in the recent years especially sectors like textile, aviation, energy, telecom etc., on account of economic slowdown, rising interest rates and export sluggishness. Restructuring would normally involve modification of sanction terms, which would generally include alteration of repayment period/installment/rate of interest/sacrifice etc. The lion share of restructure of advances pertains to Corporate Debt Restructuring (CDR).

Table 4 – Restructured Advances of all SCBs
Year	Amount (` lakh crore)	% Restructured standard advances to Gross advances
2009	0.75	2.73
2010	1.36	4.23
2011	1.38	3.45
2012	2.18	4.68
2013	3.58	5.70
Source: Economic Times dated 31.10.12 & Financial Stability Report June`13

Banks have been revising interest rates from time to time with a view to curb inflation. High interest rate increases the cost of funds to the credit users and has a debilitating effect especially on the repayment capacity of small and medium enterprises. A high rate of inflation dilutes the quality of assets of the banking sector. Weak supply demand scenario, high borrowing or leveraging and intense competition contribute to loan defaults.

Loans may turn bad due to faulty credit appraisal policies followed by the banks and delays in sanction/disbursement also make the project unviable. Banks need to have effective credit monitoring policy for follow up, but unfortunately banks are not able to follow up the loan accounts efficiently which lead to loan being difficulty to recover. Legal system is also ineffective. However, the burden of NPA’s does have a serious impact on the long-term viability of the Indian financial sector and the absence of efficient resolution mechanisms will affect the growth of credit to industry.

The ratio of Restructured Standard Advances to Gross Advances of all SCBs stood at 5.70% as on 31st March 2013. It is evident from the above that the restructured portfolio of the banking industry has been increasing many folds since 2010 which is quite alarming and disturbing. The conservative estimates of slippages will be around 25% to 30% under restructured portfolio. The recent provisioning norms issued by RBI in respect of new Restructured Standard Accounts are increased from existing 2.75% to 3.50% by 31st March 2014; 4.25% by 31st March 2015 and 5% by 31st March 2016. These norms are going to hit the banks severely on both fronts viz., Profitability and Capital adequacy.

NPA - Impact on Balance Sheet

The problem of NPAs in the Indian banking system is one of the foremost and the most formidable problems that had impact the entire banking system. Higher NPA ratio trembles the confidence of investors, depositors, lenders etc. It also causes poor recycling of funds, which in turn will have deleterious effect on the deployment of credit. The non-recovery of loans effects not only further availability of credit but also financial soundness of the banks.

Profitability: NPAs put detrimental impact on the profitability as banks stop to earn income on one hand and attract higher provisioning compared to standard assets on the other hand. On an average, banks are providing around 25% to 30% additional provision on incremental NPAs which has direct bearing on the profitability of the banks.

Asset (Credit) contraction: The increased NPAs put pressure on recycling of funds and reduces the ability of banks for lending more and thus results in lesser interest income. It contracts the money stock which may lead to economic slowdown.

Liability Management: In the light of high NPAs, Banks tend to lower the interest rates on deposits on one hand and likely to levy higher interest rates on advances to sustain NIM. This may become hurdle in smooth financial intermediation process and hampers banks’ business as well as economic growth.

Capital Adequacy: As per Basel norms, banks are required to maintain adequate capital on risk-weighted assets on an ongoing basis. Every increase in NPA level adds to risk weighted assets which warrant the banks to shore up their capital base further. Capital has a price tag ranging from 12% to 18% since it is a scarce resource.

Shareholders’ confidence:  Normally, shareholders are interested to enhance value of their investments through higher dividends and market capitalization which is possible only when the bank posts significant profits through improved business. The increased NPA level is likely to have adverse impact on the bank business as well as profitability thereby the shareholders do not receive a market return on their capital and sometimes it may erode their value of investments. As per extant guidelines, banks whose Net NPA level is 5% & above are required to take prior permission from RBI to declare dividend and also stipulate cap on dividend payout.

Public confidence: Credibility of banking system is also affected greatly due to higher level NPAs because it shakes the confidence of general public in the soundness of the banking system. The increased NPAs may pose liquidity issues which is likely to lead run on bank by depositors. Thus, the increased incidence of NPAs not only affects the performance of the banks but also affect the economy as a whole.

In a nutshell, the high incidence of NPA has cascading impact on all important financial ratios of the banks viz., Net Interest Margin, Return on Assets, Profitability, Dividend Payout, Provision coverage ratio, Credit contraction etc., which may likely to erode the value of all stakeholders including Shareholders, Depositors, Borrowers, Employees and public at large.

Way forward

Today, the banking industry has been reeling under increased incidence of NPAs while the expectations of the stakeholders are on the rise, which is a cause of serious concern. There is an imminent need to address this issue focusing attention on demand and supply side.

Prevention is better than cure. Proper evaluation of credit proposals definitely helps the banks in detecting the unviable projects at the first instance. Full information about unit, industry, its financial stake, management etc., should be collected.

Lending being a focused segment, there is an urgent need to develop specialized skills in the area of appraisal, monitoring and recovery to ensure the quality of credit portfolio. The decentralized model that is being vogue in many banks need to shift towards adoption of centralized model for sanction and recovery of Retail / Corporate loans. Separate cell should be established at the bank level, which would have complete information about the industry and its prospects in future.

Managing credit risk plays an important role and its effectiveness lies in an efficient recovery and exit strategy. Banks should be equipped with latest credit risk management techniques to protect the bank funds and minimize insolvency risks. Banks should explore the possibilities to develop credit derivatives markets to avoid these risks.

Timely follow up is the key to keep the quality of assets intact and enables the banks to recover the interest/installments in time. To have better control on the assets created out of borrowings, banks need to watch the functioning of the units by paying frequent visits and this is to be done to all the units irrespective whether the account is performing or non-performing one.

Selection of right borrowers, viable economic activity, adequate finance and timely disbursement, end use of funds and timely recovery of loans should be the focus areas for preventing or minimizing the incidence of fresh NPAs.

The key challenge going forward for Indian banks is to expand credit portfolio and effectively manage NPAs while maintaining profitability. Asset quality continues to be the core function and also biggest challenge for the banks in the present dynamic environment. Though, management of asset quality is a balance sheet issue of individual banks, it has wider macro economic implications. In order to overcome the associated risks including externalities, there is an imminent need for the banks to have well structured and effective credit monitoring system in place coupled with appropriate business models.

( Collected from www.allbankingsolutions.com