As described by the Reserve Bank of India (RBI), “An asset, including a leased asset, becomes non-performing when it ceases to generate income for the bank.” When banks give out loans to borrowers, these loans are treated as assets. In some instances, when borrowers stop providing interest and other payments for a period of time, banks treat these as NPAs.
Increasing NPAs burden the financial system and deteriorate the health of banks. As banks stop getting returns from these assets, their profitability is affected. Along with the negative effects on profitability, the loss rate of banks also increases. As the funds of the bank decrease, the future lending capacity of banks is heavily affected. These different events leave banks vulnerable to various unexpected events, namely economic shocks.
Now that the COVID-19 shock is in place, “The level of the NPAs is going to be unprecedented in six months from now if we really recognise the true level of NPAs. We are in trouble and sooner we recognise it, better it is because we really need to deal with the problem,” said Raghuram Rajan at the India Policy Forum in July earlier this year.
Take a look at the table below that indicates the Gross NPAs of banks from 2016-2019.
From the data, we can see that banks had made an overall recovery in 2019 with lower Gross NPAs compared to the previous year. This progression made by banks is now being undone by the pandemic.
Additionally, the data shows that there is a stark difference between the Gross NPA levels of public and private sector banks.
Public sector banks (PSBs) have relatively lower capital adequacy compared to private sector banks. PSBs are not efficient at managing their NPA ratios, even the technology used by these banks is not as leveraged compared to private sector banks. Another contributing factor to relatively high levels of Gross NPAs in the PBSs is the vulnerability of these banks to promote certain economic sectors of society due to political pressure.
The stabilization of PSBs and restructuring of their financial affairs is essential for the PSBs to absorb the shocks caused by the COVID-19 pandemic.
During times of an economic crisis, testing the resilience of financial institutions becomes imperative for the government to get a ground reality of the situation. Doing this helps the government understand how volatile the market is. Once the assessment is made, governments can then apply relevant reforms to stabilize the financial system.
To assess the current health of banks in India, stress tests were taken by banks under certain guidelines of the RBI. Though it was known that the results of the tests would be disappointing, they are far worse than expected. Reports show that the Gross NPA ratio of the banking sector is likely to increase from 8.5% in March 2020 to 12.5% by March 2021, or even up to 14.7%, if adequate measures are not taken. While the GNPA ratio of the PSBs is expected to increase from 11.3% in March 2020 to 15.2% by March 2021, the private sector banks are expected to increase from 4.2% in March 2020 to 7.3% by next year.
We should be extremely worried about high NPA levels as it starts a chain of deteriorating financial events. High NPAs lead to low profitability of banks. The lending capacity of banks as well as their income decreases. Additionally, since the banks are unable to increase their lending, money flow is reduced. To add to this, the confidence that the public has on the banking system is heavily impacted and shareholders start contracting their investments. Thus, the issue of rising NPAs is not just an issue that banks individually face but is an issue that impacts the financial system of the country and in turn the economy.
In an attempt to curb the financial distress caused by the pandemic, the RBI attempted to bless financial borrowers by extending the moratorium on all term loans by six months. Though the moratorium ended on August 31, the government recently announced an extension that allows for a two-year loan moratorium in the case that a borrower’s cash flow has directly been affected by the pandemic. An interest rate cut has also been issued to boost the economy.
While there is an appraisal that the new monetary policy is accommodative to the plight of the borrowers, it is unlikely that this policy is going to ease the financial burden faced by the banks. The balance sheets of banks may improve, they may gain temporary relief from the pressure caused by NPAs and even increase market liquidity by increasing the amount of money that banks may have in hand, either to invest or to spend. The fact remains that the lending capacity of banks will not improve as the amount of money flowing will remain restricted. People’s spending capacity is not going to improve for a while and even with loan extensions, it remains uncertain whether the NPAs would get converted to profitable assets in the future financial years.
Before India was struck with the COVID-19 pandemic, the banking sector already faced issues with poor health. Bad loan judgements, ineffective asset management strategies and over-relaxed lending norms have previously contributed to high NPAs of banks. For an emerging economy like India, the road to recovery is going to be a difficult process indeed. While it is imperative for banks to internally re-structure lending processes, the RBI and the government also play an important role in the strengthening of bank systems.
Shrishti is a Politics, Philosophy and Economics major at Ashoka University. In her free time, you’ll find her cooking, dancing or photographing.
We publish all articles under a Creative Commons Attribution-Noderivatives license. This means any news organisation, blog, website, newspaper or newsletter can republish our pieces for free, provided they attribute the original source (OpenAxis).