BANKING SYSTEM IN INDIA – NON PERFORMING ASSETS

INTRODUCTION

In the last article on “Understanding the banking system“, we had discussed the Basel norms.

We learnt what Basel norms are and why they hold such importance for the Indian banking system. Then we understood the challenges the banks will have to face in implementing them. Further, we suggested a possible way out.

Previous discussion highlighted why stability in the banking system is important. Following that discussion, in this article we will be discussing one of the biggest challenges threatening the stability of the Indian banking system – the Non-Performing assets (NPAs).

The banking business has boomed since Independence, particularly after the LPG reforms. The sector is currently valued at Rs 115 lakh crore and expected to more than double at Rs 288 lakh crore by 2020. Out of this 70 per cent of business is being done by PSU banks. An interesting fact is that SBI’s market share out of total banking business is 22 per cent!

Looking at the enormous size of the banking industry, the NPAs are a big cause of concern.

We will first look at some of the basics of NPAs; then move on to understand their causes and implications; then examine the challenges that the banks will face because of them; and finally put forward possible solutions.

The discussion will also cover the social agenda behind the banking and whether it is unviable for the Indian banks.

WHAT ARE NPAS?

Generally speaking, NPA is any asset of a bank which is not producing any income.

In other words, a loan or lease that is not meeting its stated principal and interest payments.

On a bank’s balance sheet, loans made to customers are listed as assets. The biggest risk to a bank is when customers who take out loans stop making their payments, causing the value of the loan assets to decline.

Criteria

Loans don’t go bad right away. Most loans allow customers a certain grace period. Then they are marked overdue. After a certain number of days, the loan is classified as a nonperforming loan.

Banks usually classify as nonperforming assets any commercial loans which are more than 90 days overdue and any consumer loans which are more than 180 days overdue.

For agricultural loans, if the interest and/or the installment or principal remains overdue for two harvest seasons; it is declared as NPAs. But, this period should not exceed two years. After two years any unpaid loan/installment will be classified as NPA.

Categories

1. Sub-standard: When the NPAs have aged <= 12 months.

2. Doubtful: When the NPAs have aged > 12 months.

3. Loss assets: When the bank or its auditors have identified the loss, but it has not been written off.

After a certain amount of time, a bank will try to recoup its money by foreclosing on the property that secures the loan. The way money is recouped is a highly contentious issue not just with banks but also with Micro-Finance Institutions (MFIs). We will discuss it later in the article.

All of this can be explained in a much more technical manner, but that is not required here. For example, we do not need to list all the conditions that make the banks declare an asset as NPAs like ” In respect of derivative transactions, the overdue receivables representing positive mark-to-market value of a derivative contract, if these remain unpaid for a period of 90 days from the specified due date for payment.”

Only understanding the basic concepts will suffice. UPSC is not going to ask you these details, but about the impact and solutions of NPAs. Even in prelims, these details will not be asked. So we avoid technicalities and jargons here. It is not useful for a GS paper, even if some of it may be useful for Economics optional paper.

EXTENT OF NPAs

Gross NPAs of domestic banks jumped to 4.2 % of total lending by the end of September 2013 from 3.6 % six months before, according to the Reserve Bank of India (RBI).

As per a recent warning by the RBI, bad loans (NPAs) could climb to 7% of total advances by 2015.

In absolute terms, gross NPAs are estimated to touch Rs 2.50 lakh crores by the end of March this year. This is equal to the size of the budget of Uttar Pradesh. The biggest chunk of the soured debts is with state-run banks (Public sector banks or PSBs), which account for two-thirds of loans but 80 % of the bad assets.

This is how the NPA curve has been moving in the recent years, as per a news report in the Business Standard:

Private-sector and foreign lenders are better placed. Their NPAs in proportion of their lending is lesser than that of the PSBs.

WHY IT MATTERS?

The higher is the amount of non-performing assets (NPAs), the weaker will be the bank’s revenue stream.

In the short-term, many banks have the ability to handle an increase in nonperforming assets — they might have strong reserves or other capital that can be used to offset the losses. But after a while, if that capital is used up, nonperforming loans will imperil a bank’s health. Think of nonperforming assets as dead weight on the balance sheet.

Here is the impact of the NPAs:

• As the NPA of the banks will rise, it will bring a scarcity of funds in the Indian security markets. Few banks will be willing to lend if they are not sure of the recovery of their money.
• The shareholders of the banks will lose a lot of money as banks themselves will find it tough to survive in the market. 
• This will lead to a crisis of confidence in the market. The price of loans, i.e. the interest rates will shoot up badly. Shooting of interest rates will directly impact the investors who wish to take loans for setting up infrastructural, industrial projects etc. 
• It will also impact the retail consumers like us, who will have to shell out a higher interest rate for a loan. 
• All of this will lead to a situation of low off take of funds from the security market. This will hurt the overall demand in the Indian economy. And, finally it will lead to lower growth rates and of course higher inflation because of the higher cost of capital.
• This trend may continue in a vicious circle and deepen the crisis.
• Total NPAs have touched figures close to the size of UP budget. Imagine if all the NPA was recovered, how well it can augur for the Indian economy.

RBI governor Raghuram Rajan has recently said that NPAs must be curbed before the problem becomes alarming.

WHY SUCH A SITUATION?

The rising incidence of NPAs has been generally attributed to the domestic economic slowdown. It is believed that with economic growth slowing down and rate of interest going up sharply, corporates have been finding it difficult to repay loans, and it has added up to rising NPAs. Even finance minister P Chidambaram stated that bad loans are a function of the economy and hence, having bad loans during distressed times is very natural.

However, The NPA mess is not entirely because of the reversal of economic cycles.

Here we look at the other reasons behind this mess. Basically the whole problem can be divided into two parts – External problems and internal problems as faced by the banks.

External Factors 

Reasons related to the corporate sector

1. Apart from the slowdown in India, the global economy has also slowed down.
   This has adversely impacted the corporate sector in India. Continuing uncertainty in the global markets has lead to lower exports of various products like textiles, engineering goods, leather, gems etc. It can be noted that imports and exports combined equal to around 40% of India’s GDP! 
   A hurt corporate sector is finding it difficult to pay loans 
2. The ban in mining projects, delay in environmental related permits affecting power, iron and steel sector, volatility in prices of raw material and the shortage in availability of power have all impacted the performance of the corporate sector. This has affected their ability to pay back loans.
   
   

Other sectors

1. Banks in India are highly regulated. Priority sector lending (PSL) is one of these regulations which require the banks to give a certain % of their loans to certain sections of society. These are farmers, SCs, STs, IT parks, MSMEs etc.
   Naturally one would assume that the weaker sections covered under PSL are the ones to be blamed for the situation. However, it is not the case.
   As per recent news reports, the Standing Committee on Finance will be now examining the reasons for high NPAS in PSBs.
   The data, shared with the Standing Committee, shows that NPAs in the corporate sector are far higher than those in the priority or agriculture sector.
   Within the priority sector, incremental NPAs were more in respect to micro small and medium enterprises followed by agriculture.

However, even the PSL sector has contributed substantially to the NPAs.

As per the latest estimates by the SBI, education loans constitute 20% of its NPAs!

The sluggish legal system (Judiciary in India) and lack of systematic and constant efforts by the banks make it difficult to recover these loans from both corporate and non-corporate.

Internal Factors

1. Indiscriminate lending by some state-owned banks during the high growth period (2004-08) is one of the main reasons for the deterioration in asset quality.

2. Bankers say there is a lack of rigour in loan appraisal systems and monitoring of warning signals at state-run banks. This is particularly true in case of infrastructure projects, many of which are struggling to repay loans. Besides, these projects go on for 20 to 30 years.

 3. Poor recovery and use of coercive techniques by banks in recovering loans

4. The wait and watch approach of banks have been often blamed as the reason for rising NPAs as banks allow deteriorating asset class to go from bad to worse in the hope of revival and often offer restructuring option to  corporates.

A Parliamentary panel, examining increasing incidents of NPAs, has observed that state-owned banks should stop “ever-greening” or repeated restructuring of corporate debt to check the constant bulging of their non-performing assets. Members of the panel were of the view that NPAs are the result of bad economic situation, but there were also management issue of every-greening of loans, which could be avoided by “not renewing loans, particularly of corporate”.

Therefore, it can be clearly seen that it is only the economic slowdown that is behind the NPAs. There are a whole range of factors.

WAY OUT

The simplest approach to cut down NPAs is to recover the bad loans. 

Apart from the regular guidelines released by the RBI, to strengthen further the recovery of dues by banks and financial institutions, Government of India promulgated:

1.The Recovery of Debts Due to Banks and Financial Institutions Act, 1993

2. The Securitization Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002. 

So, how can the banks legally recover their loans?

(i)     The Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest (SARFAESI) Act, 2002 – The Act empowers Banks / Financial Institutions to recover their non-performing assets without the intervention of the Court, through acquiring and disposing of the secured assets in NPA accounts with outstanding amount of Rs. 1 lakh and above. The banks have to first issue a notice. Then, on the borrower’s failure to repay, they can:

• Take possession of security and/or
• Take over the management of the borrowing concern.
• Appoint a person to manage the concern.

(ii) Recovery of Debts Due to Banks and Financial Institutions (DRT) Act: The Act provides setting up of Debt Recovery Tribunals (DRTs) and Debt Recovery Appellate Tribunals (DRATs) for expeditious and exclusive disposal of suits filed by banks / FIs for recovery of their dues in NPA accounts with outstanding amount of Rs. 10 lac and above.  Government has, so far, set up 33 DRTs and 5 DRATs all over the country.

(iii) Lok Adalats:  Section 89 of the Civil Procedure Code provides resolution of disputes through ADR methods such as Arbitration, Conciliation, Lok Adalats and Mediation. Lok Adalat mechanism offers expeditious, in-expensive and mutually acceptable way of settlement of disputes.

Government has advised the public sector banks to utilize this mechanism to its fullest potential for recovery in Non-performing Assets (NPAs) cases.   

Among the various channels of recovery available to banks for dealing with bad loans, the SARFAESI Act and the Debt Recovery Tribunals (DRTs) have been the most effective in terms of amount recovered.

The recent controversy surrounding loan recovery in India – Views of the SC

Banks have been alleged to engage in coercive practices to recover the loans. Recently, there have been some judicial pronouncements by the apex court determining the scope of powers of enforcement of securities without the intervention of the courts, by the banks and FIs under the SARFAESI Act. The apex court has reiterated the need to protect the interest of borrowers, and emphasized that the exercise of extraordinary powers of recovery, by banks and FIs must be in compliance with the provisions of the SARFAESI Act.

As per the Supreme Court (SC) – “”Liquidity of finances and flow of money is essential for any healthy and growth oriented economy. But certainly, what must be kept in mind is that the law should not be in derogation of the rights which are guaranteed to the people under the Constitution. The procedure should also be fair, reasonable and valid, though it may vary looking to the different situations needed to be tackled and object sought to be achieved.”

But, these are steps which cure the disease of NPAs. “The issue of NPAs needs to be tackled at the level of prevention rather than cure.”

Therefore, the steps that can prevent the piling up of NPAs are as follows:

1. Conservatism:

Banks need to be more conservative in granting loans to sectors that have traditionally found to be contributors in NPAs. Infrastructure sector is one such example. NPAs rise predominantly because of long gestation period of the projects. Therefore, the infrastructure sector, instead of getting loans from the banks can be funded from Infrastructure Debt Funds (IDFs) or other specialized funds for infrastructural development in the country.

2. Improving processes:

The credit sanctioning process of banks needs to go much more beyond the traditional analysis of financial statements and analyzing the history of promoters. For example, banks rely more on the information given by credit bureaus. However, it is often noticed that several defaults by some corporate are not registered in their credit history.

3. Relying less on restructuring the loans:

Instead of sitting and waiting for a loan to turn to a bad loan, and then restructure it, the banks may officially start to work to recover such a loan. This will obviate the need to restructure a loan and several issues associated with it. One estimate says that by 2013 there will be Rs 2 trillion worth of restructured loans.

4. Expanding and diversifying consumer base by Innovative business models:

Contrary to popular perceptions,the NPA in non-corporate sector is less than that in the corporate sector. Hence, there is a need to reach out to people in remote areas lacking connectivity and accessibility. More and more poor people in rural pockets should be brought under the banking system by adopting new technologies and electronic means. Innovative business models will play a crucial role here. Otherwise, the NPAs may increase instead of decreasing.

As said by the new M.D. of SBI, Mr. Viswanathan proposed ideas such as a single demat account for all investments and credit cards for school students (above class 8th) to make them aware with the banking system.

CONCLUSION

Looking at the giant size of the banking industry, there can be hardly any doubt that the menace of NPAs needs to be curbed. It poses a big threat to the macro-economic stability of the Indian economy. An analysis of the present situation brings us to the point that the problem is multi-faceted and has roots in economic slowdown; deteriorating business climate in India; shortages in the legal system; and the operational shortcoming of the banks. Therefore, it has to be dealt at multiple levels. The government can’t be expected to rescue the state-run banks with tax-payer’s money every time they fall into a crisis. But, the kind of attention with which this problem has been received by policymakers and bankers alike is a big ray of hope. Right steps, timely and concerted actions and a revival of the Indian economy will put a lid on NPAs. Prevention, however, has to become a priority than mere cure.

UNDERSTANDING EL NINO AND LA NINA PHENOMENA AND THEIR IMPLICATION ON INDIA

Introduction

Monsoon is a familiar though a little known climatic phenomenon. In India, from agriculture to economic policies to disaster management, a lot depends on the Monsoon.

The Monsoon is a recurring event i.e. it repeats after a certain frequency of time – a year in our case. But, it may not be uniform in every period (year). There are a lot of factors which affect its duration and intensity over India.

The Monsoon is basically a result of the flow of moisture laden winds because of the variation of temperature across the Indian Ocean.

There are a number of climatic phenomena which affect it namely the Indian ocean dipole, El nino, La nina, Equatorial Indian Ocean Oscillation (EQUINOO) etc. These phenomena affect the temperature distribution over the oceans and thus affecting the direction and intensity of flow of the moisture laden winds.

There have been recent reports that El Nino may disturb the Indian Monsoon and play badly with Indian agriculture. This brings us to the discussion of the concepts of El Nino and La Nina. In what follows we will look at their origin, mechanism, impact and mitigation strategies. We need not go into trivial details but only understand them from exam point of view.

Origin

El Nino and La Nina are opposite phases of what is known as the El Niño-Southern Oscillation (ENSO) cycle. The ENSO cycle is a scientific term that describes the fluctuations in temperature between the ocean and atmosphere in the east-central
Equatorial Pacific. (The area between South America and Australia near the equator – look at the diagram)

   West  East

La Nina is sometimes referred to as the cold phase of ENSO and El Nino as the warm phase of ENSO. These deviations from normal surface temperatures can have large-scale impacts not only on ocean processes, but also on global weather and climate, including India.

  Mechanism

NOW, it is important to understand how these phenomena affect the Monsoon system? To know this, we must first know the pressure and temperature distribution in the region before their onset. (We are assuming here that you are a little bit familiar with the phenomenon of Monsoon.)

For a normal monsoon season, the pressure distribution is as such:

1. The Peruvian coast has relatively high pressure than the areas near north Australia and South-East Asia.
2. The Indian Ocean is slightly warmer than the adjoining oceans (West pacific –see diagram) and thus the pressure is low relatively due to the warm seas. This is why the moisture laden winds move from near the west pacific to the Indian Ocean and from there on to the lands.
3. The pressure on heated Indian land is much lower than that on the Indian Ocean.

This facilitates the movement of monsoon winds from the sea to the Indian land without any significant diversion.

But if for some reason this normal distribution is affected, then there is a change in the way trade winds (or monsoon winds) would blow.

However, the following is the pressure and temperature distribution in an El-Nino situation.

        

This is because of the following reasons (and its effects):

Off the coast of Peru (read in Eastern Pacific and Central Pacific), there is normally cool surface water because of the cold Peruvian current. But El Niño makes it go warm.

When the water becomes warm, the tread winds, which otherwise flow from East to west, either reverse their direction or get lost.

Due to this warm water, the air gets up and surface air pressure above Eastern Pacific gets down. On the other hand, the waters cool off in western pacific and off Asia. This leads to rise in surface pressure over the Indian Ocean, Indonesia, and Australia.

Now as the pressure over the Peruvian coast reduces because of the warm sea water, the flow of moisture laden winds is directed to the Peruvian coasts from the western pacific (the areas near North Australia and South-east Asia – refer to the diagrams above).

Hence, the moisture laden winds that should have moved towards the Indian coast now move towards the Peruvian coast.

The warm water causes lots of clouds getting formed in that area, causing heavy rains in Peruvian desert during El Niño years.

This robs the Indian subcontinent of its share in the Monsoon rains. The greater the temperature and pressure difference, the greater would be the shortage in the rainfall in India.

La-Nina

La Niña, “anti-El Niño” or simply “a cold event” is the cooling of water in the Eastern Pacific Ocean.

The following happens in La-Nina:

The water in Eastern Pacific, which is otherwise cool; gets colder than normal. There is no reversal of the trade winds but it causes strong high pressure over the eastern equatorial Pacific.

On the other hand, low pressure is caused over Western Pacific and Off Asia.

This has so far caused the following major effects: Drought in Ecuador and Peru. Low temperature, High Pressure in Eastern Pacific.

Heavy floods in Australia; High Temperature in Western Pacific, Indian Ocean, Off coast Somalia and good rains in India. Drought in East Africa.

For India, an El Niño is often a cause for concern because of its adverse impact on the south-west monsoon; this happened in 2009. A La Niña, on the other hand, is often beneficial for the monsoon, especially in the latter half. The La Niña that appeared in the Pacific in 2010 probably helped 2010’s south-west monsoon end on a favorable note. However, it also contributed to the deluge in Australia, which resulted in one of that country’s worst natural disasters with large parts of Queensland either under water from floods of unusual proportions or being battered by tropical cyclones.

 Periodicity

This distortion is pressure and temperature recurs every 4-5 years. But it may not happen exactly after 4-5 years or it may not happen at all. It periodicity is thus quite uncertain.

El Nino and La Nina episodes typically last nine to 12 months, but some prolonged events may last for years. They often begin to form between June and August, reach peak strength between December and April, and then decay between May and July of the following year. While their periodicity can be quite irregular, El Nino and La Nina events occur about every three to five years. Typically, El Nino occurs more frequently than La Nina.

  Correlation of El-Nino, La- Nina and drought in the Indian Landscape

“Looking at the relation between El Nino and Indian droughts since 1950, it is observed that India faced 13 droughts and 10 of these were in El Nino years and one in a La Nina year. This indicates there may not be a one-to-one correspondence between El Nino and Indian droughts,” the paper by Ashok Gulati and Shweta Saini of Indian Council for Research on International Economic Relations (ICRIER) has stated.

“Overall, the analysis proves that since the 1980s, only El Nino years converted into droughts for our country. However, a La Nina year does not guarantee better-than-normal rains and similarly
an El Nino year does not always translate into below-normal rains,” it said.

The paper also stated that as El Nino phenomenon may hit in the second half of the monsoon season in 2014, factors such as favourable water reservoir levels, and high stocks of grains with the government may offer relief to farmers and consumers.

  Impact of El-Nino

• Normal or High rainfall in Eastern/Central Pacific
• Drought or scant rainfall in western pacific/Asia

This leads to a lot of undesirable circumstances.

“When the rainfall for the monsoon season of June to September for the country as a whole is within 10% of its long period average, it is categorised as a normal monsoon. When the monsoon rainfall deficiency exceeds 10%, it is categorised as an all-India drought year.” – IMD

• In India, almost 50% of the area under cultivation is rain-fed. Indian agriculture is thus heavily dependent on the climate of India: a favorable southwest summer monsoon is critical in securing water for irrigating Indian crops. So, a significant reduction in total rain fall results in a drought like situation.
  Drought in India has resulted in tens of millions of deaths over the course of the 18th, 19th, and 20th centuries.
  In some parts of India, the failure of the monsoons result in water shortages, resulting in below-average crop yields.
  This is particularly true of major drought-prone regions such as southern and eastern Maharashtra, northern Karnataka, Andhra Pradesh, Odisha, Gujarat, and Rajasthan.
  A lot of Farmers suicide because they are not be able to repay the loan they had taken for growing the crop.
  
  
  
  

    Shortages in food supply then result in spike in food prices all across the country pushing inflationup. High food inflation eats into other sectors too such as food processing sector.

    This pushes the RBI and the government to adopt a more cautious approach to monetary and fiscal policy respectively.

A tighter monetary policy to tame food inflation may affect the economic growth rate of the nation. Besides, lower agricultural production already lower the GDP of the nation dealing a double blow.

• If the drought is severe, it would dry up major sources of fresh water leading to a water crisis like situation. The ground water level will also go down. This would not only affect supply of drinking water, but also supplies of water into canals and hand-pumps for agricultural irrigation.
• Weak monsoons also result in lesser power generation from hydro power dams thus leading to even lesser electricity for irrigation purposes. This further reduces the crop yield.
• Another important source of income for the farmers is livestock and the fisheries. Both are affected severely by the drought.

 What is the WAY OUT?

Near-term Solutions

1. The government must expand the farm insurance cover and advice banks and financial institutions to settle crop insurance claims in the drought-hit areas without delay. Otherwise, we will be seeing a lot of farmer suicides.
   
   
2. High quality seeds of alternative crops must be distributed among farmers in the drought-affected areas.
   
   
3. The government must realistically assess the ground level situation in order to estimate the shortfall of oilseeds and pulses and help traders with market intelligence.
   
   
4. It should also bring down the cereals’ inflation by liquidating the extra stock it was holding, which is way above the buffer requirement.
   
   
5. Scrapping the APMC Act and allowing free flow of agriculture goods among the states. This would help bridge the mismatch of demand and supply of goods, which is the underlying factor contributing inflation.
   
   
6. The distribution of pulses through public channels at subsidised prices as was done in 2008 to all the households is needed.
   
   
7. The government should also provide the fuel subsidy that enables farmers to provide supplementary/alternative irrigation through pump sets in the drought and deficient rainfall areas to protect the standing crops.

Long-term solutions

1. 
   
   1. Developing drought free crop varieties and distributing its subsidized seeds to the farmers. It is a part of National Action plan on climate change in Agriculture.
      
      
   2. Strengthening the crop insurance regime in India by making the drought identification, drought and crop loss claim and receipt of relief efficient, quick and transparent.
      
      
   3. Achieving financial inclusion so that the farmers are able to take loans from more credible, accommodative and benevolent sources such as regional rural banks (RRBs). This would help them tackle distress like situations.
      
      
   4. Using low water use technologies like drip and sprinkler irrigation.
      
      
   5. Moving away from water intensive crops to less water consuming crops. The MSP regime in India has to provide more remuneration for other less water consuming crops. As in India, about 80% of the water is used for agricultural purposes, a lot of which is used by crops such as rice.
      
      
   6. Strengthening community watershed management and development. This can be done by protecting and conserving local water sources like ponds, lakes etc. Several government schemes like MGNREGA, Integrated watershed Development Programme etc. can be utilized in this.
      
      
   7. Developing early warning systems and alerting the farmers much in advance like in the recently launched Kissan SMS scheme.