Start worrying about those NPAs: Financial Express, 18th May 2012

While the elasticity of NPAs with respect to industrial growth has been range-bound, this rose sharply in last two quarters The issue of quality of assets of the banking system is of paramount importance, given that the future of banking will be to strike a balance between business and profit growth with prudential practices, which involves both maintaining capital and controlling the quality of assets. Basel III talks of the requirement of raising more of ‘own’ capital, which is a challenge for both public and private banks—the former because it involves issue of ownership and disinvestment and the latter because their risk-weighted assets are higher, given their business models. But, quality of assets is a concern for all banks, especially so since the economy has begun to decelerate and the overall economic conditions for FY13 do not appear to look any better than they were in FY12. Just how serious is this issue? The last two years have been particularly challenging for banks where they had to contend with the phenomena of rising interest rates for two years, and a slowdown in industrial growth in FY12. Bank credit growth, on the other hand, has been a mixed bag, being interspersed with varying trends. Chart 1 traces the movement of gross NPAs to total advances for a set of 36 banks for the last eight quarters. There has been a tendency for gross NPAs to increase between April-December 2011, from 2.25% as on March 2011 to 2.85% in December. Excluding SBI (results not yet out for March 2012), the ratio would stand at 2.40% in March 2012 as against 2.43% in December 2011 for 35 banks. These numbers by themselves do not really provide discomfort, given that it has been a difficult year for the banking system. It has however also been noticed that corporate profitability has slowed down, with growth in net profits also turning negative in the quarters ending December and March. This means that going ahead there would be pressures on corporates to perform in terms of servicing their debts. However, these numbers could be indicative of the emerging scenario of quality of assets of banks going ahead, given that the economic climate is uncertain. Chart 2 provides the movement of the elasticity of growth in gross NPAs to growth in advances along with the elasticity of growth in gross NPAs with respect to industrial growth. The elasticity with respect to advances has been high in the last three quarters of calendar 2011, which also indicates that NPAs grew faster during this time period. The second relation with industrial growth however is more interesting. The elasticity of NPAs with respect to industrial growth has been range-bound, between 0.25 and 0.38. However, in the last two quarters, i.e. September and December 2011, the elasticity has increased sharply to 0.86 and 2.42, respectively. While these numbers per se may not be significant, the indication is that in case industrial growth continues to be downbeat then the level of NPAs will increase further, which is definitely a concern. And currently, with an unchanged economic environment in the country, it looks unlikely that there would be a quick turnaround in the state of industry. In fact, with GDP growth to be only marginally higher in FY13 according to RBI, industry is likely to follow a sluggish path. Chart 3 shows how net NPAs have moved over the quarters. After showing a declining trend towards March 2011, there has been a tendency for them to rise again. This has certainly affected the profitability of banks through provisions and write-offs. The issue with growing NPAs is that it is a two-way force with economic growth. While slower economic growth increases the probability of default, the same makes banks more conservative with their lending, which, in turn, can impact growth. Banks would tend to get choosier with lending and cherry pick their customers so that the higher-rated clients are preferred. This would also lead to an increase in the cost of credit for borrowers who have lower ratings. In particular, the SME segment is to be negatively impacted as it also does not have access to other avenues like the ECB route which is open for the large companies. The other consequence is that there would be greater demand for restructuring of sticky loans, especially in case of sectors such as MSME, aviation, telecom, real estate and infrastructure including power. This would further pressurise banks. The solution really is for banks to be more discreet while lending in uncertain times. They should also have in place an early warning signal for detecting possible delinquencies and should be mapping continuously industry performance to prepare with a suitable response. Companies should be encouraged to hedge their commodity and currency risk, which are useful insurance tools going ahead, considering that economic conditions are going to remain volatile with the euro crisis still looming and domestic economic conditions still being sticky. Further, one could also think of a counter-cyclical buffer for NPAs when provisions are made in better years for covering NPAs during tough times, just as for capital as laid down under Basel III framework.