The economic health of a banking system is highly correlated with the performance of overall economy. When things are good, banks reap the benefit of their business model i.e. taking calculative risks. On the other hand, when economic activity slows down these very risks go bad thus impacting the bottom line of the bank. COVID-19 pandemic has certainly impacted the economic activity and plausibly increase in banking NPA.
Banking Business Model
In laymen terms, the banking business is to borrow cheaper and lend costlier! On one leg, banks accumulate liabilities (borrow) from CASA (current and saving accounts), fixed deposits and certificate of deposits. On the second leg, banks create assets (by lending) funds to corporates, individuals via working capital financing, term loans, education loan, home loan and many more. The decision to lend and interest rate of lending depends upon the credit profile of a borrower. During the economic boom, as business income increases even low credit rated borrower continue to repay loans on the other hand, during slowdown as business income reduces even high credit rated borrower find it difficult to repay loans. When a borrower cannot service a loan, it is termed as non-performing assets (NPAs) in the bank’s book.
Non-Performing Assets Brief Background
The roots of Indian NPA crisis goes way back to the 2008 financial crisis. To combat slowdown, Government and public sector banks had gone into overdrive in lending without adequately monitoring corporates and promoters. As per, former RBI Governor Raghuram Rajan “this historic phenomenon of irrational exuberance” was at a core of NPA crisis. This crisis was further accentuated by the lack of monitoring by RBI and unnecessary meddling by UPA government.(Former RBI Governor -Urjit Patel). Moreover, Banks were evergreening the loans and under-reporting the non-performing assets. The recognition of bad loans was forced by the implementation of Asset Quality Review (AQR) launched by RBI in 2015. Ever since then, Banks have recognized the majority of bad assets but the recovery and reforms remained too little too late.
Insolvency and Bankruptcy Code(IBC) has started to show results as Gross NPAs declined from 11.2% in FY-18 to 8.7% in March-19. As shown in the figure, in first three-quarters of FY-20, GNPAs remained broadly unchanged at 8.7% in scheduled commercial banks (SCBs). The march quarter witnessed steep improvement in gross NPAs primarily due to aggressive write-off of public and private banks. Despite lower GNPAs, banks have preferred to increase provisioning amid fear rising bad loans due to COVID-19.
Plausible Impact of COVID on NPAs
Due to initial lockdown imposed by the Government to curb the increase of coronavirus cases, economic activity had come to a near standstill except for health care and essential items. This had resulted in nearly zero income for business class and job losses for salary class individuals. Although, the government has removed a lot of restrictions and announced INR 20 trillion Atamnirbhar package. The underline economic activity is still very tepid and will take many months to go back to pre-pandemic levels. In such conditions, cash-crunch corporates (Including MSMEs) and middle-class individual find it very difficult to service their debt.
Understanding the gravity of the situation and likely impact of loan defaults on banking system, RBI has announced moratorium on business and individual loans. As shown in chart(As on 30th April-20) below, 50% of total loan book of scheduled commercial banks had come into moratorium. This underlines the severity of the situation. MSME segment was worst affected as 65.3% of MSMEs had opted for moratorium against 56.2% individuals. It is well known that moratorium does provide required short-term liquidity but it comes with its own cost.
As lockdown restrictions have eased, loan book under moratorium has reduced considerably, for instance, private sector banks HDFC and Axis have announced loan moratorium book less than 10%. State bank of India, which had 20% book under moratorium, expects that RBI might not increase blanket moratorium.
What Future Holds?
As Deepak Shenoy wrote to his PMS investors – ‘Second order, after wave of liquidity’. “The second order, for the financial ecosystem, is only after November 30. That’s three months after the current moratorium expires. That’s when we will know how bad the economy has been hit, and what really will recover.” As per, RBI’s financial stability reports gross NPAs is likely to surge 12.5% in march-21 from 8.5% in march-20. In case macro-factors further worsen gross NPAs might surge above 14%. It is expected that RBI might relieve NPA norms for certain sectors but a broader increase in NPAs is likely put a lot of stress on under-capitalized PSU banks and few private sector banks. As per RBI’s financial stability report systematic capital adequacy ratio of SCB’s is likely to decline from current levels of 14.6% in Mar-20 to 13.3% in Mar-21. It might further fall to 11.8% under severe stress conditions. At last, private sectors banks have already started raising capital to buffer against surging NPAs. The Government should also act soon by either merging PSBs or recapitalize them or start looking at the possibility of privatizing them!
This article is the First Part of our NPA Series. Follow Roads2Future to read the other parts of the series too.
Prashant Jain, FRM, is a banking professional with 6+ years of experience in currency markets. He writes about monetary and fiscal developments. He has been associated with teaching for the last 5 years. He has a keen interest in politics and cricket.