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The authors are Arya Vansh Kamrah and Gurumurthy Cherukuthota, fourth year students at Symbiosis Law School, Pune.
Introduction
An asset is deemed to be a Non-Performing Asset (“NPA”) when the income generation function of the same culminates. The Reserve Bank of India (“RBI”) defines a Non-Performing Asset as a loan or credit in respect of which the interest or installment of the principal is due for more than 90 days. NPAs impede the growth of the banking sector in any economy. Unmonitored and uncontrolled increase in the rates of NPAs severely impacts the profitability of the banking companies. According to former RBI Governor Raghuram Rajan, over-optimism, slow-economic growth, government restrictions, loss of bank interest and malfeasance are some of the catalysts of NPAs in India.
Several economic studies indicate that Public Sector Banks (“PSBs”) in India have higher NPA rates than the Private Sector Banks (“PVBs”). Higher NPAs are often attributable to liberal credit policies including lax credit recovery practices of the PSBs, their lower rates of interest, and State repression to fund priority sectors of the economy. This article attempts to explore solutions to the NPA crisis in PSBs in India, emphasizing privatisation as a potential solution.
State Ownership of Banks and NPAs
The banking system in India majorly consists of Commercial Banks and Cooperative Banks, of which the Commercial Banks account for more than 90% of the banking system’s assets. Based on ownership, Commercial Banks can be further grouped into three major types - (i) State-owned or Public Sector Banks (PSBs), (ii) Private Banks (PVBs) under Indian ownership, and (iii) Foreign Banks (“FBs”) operating in India.
At the end of 2021, PSBs accounted for over 60% of the total assets in the Indian Banking industry, with the PVBs and FBs controlling 33% and 6.4%, respectively. The majority (around 70%) of the burden of NPAs originates from the PSBs. In this context, it is pertinent to examine the relationship between State ownership of Banks and the growth of NPAs in India.
The growth of NPAs in India is associated with several factors like business failures, industrial recession, poor government policies, externalisation and wilful defaults, among others. However, one major reason specifically associated with the increasing NPAs in the PSBs is the inevitable exposure of the PSBs to the industrial sector in general and the stressed sectors of the economy. Firstly, the Global Financial Crisis (“GFC”) of 2008 and the subsequent domestic economic slowdown deteriorated the financial health of the corporate and MSME sectors, adversely impacting credit quality and leading to an increase in NPAs in PSBs. PSBs, which had significant exposure to big-ticket corporate loans, also experienced a significant deterioration in asset quality compared to private sector banks, as evidenced by Finance Ministry data. Secondly, the PSBs (in cooperation with the Government and the RBI), in contrast to PVBs and FBs, indirectly hold a disproportionate magnitude of the responsibility of preventing domestic recession in the country. The decisions of the Government and the RBI to cut tax rates, infuse more capital and write-off loans of huge corporate players (which often form a large share in the credit portfolios of PSBs) directly affect the growth of NPAs in the PSBs. Lastly, while studies suggest no significant or positive correlation between Priority Sector Lending (“PSL”) and the growth of NPAs, the indirect burden on the PSBs to provide adequate credit facilities for PSL cannot be ignored. Therefore, there is a rather complex and profound correlation between State ownership of Banks and the growth of NPAs in India.
What Private Banks do Differently?
As discussed earlier, PVBs have lower NPAs in comparison to PSBs. Hence, it is imperative to examine the distinctive banking practices of PVBs.
Credit Risk Management
PVBs excel in the field of credit risk management vis-à-vis the PSBs. One of the key indicators of better credit risk management is a higher Capital Adequacy Ratio (“CAR”) witnessed in the PVBs (around 18 %) as against PSBs (around 14%), which in turn provides a higher rate of stability to the PVBs.
●Priority Sector Lending versus Non-Priority Sector Lending: PVBs in India are better credit risk managers due to their propensity to avoid extension of credit to the unstable and stressed sectors of the economy like the agricultural sector. Alternatively, PVBs tend to extend credit to relatively stable sectors like the housing sector, and the retail sector, among others.
●Reluctance towards Credit Consolidation: RBI’s Financial Stability Report (June 2022) stipulates that high credit to Special Mention Account (“SMA”) Loans leads to an increased risk of stressed assets. PVBs avoid extending huge credit lines to a single borrower. This creates a conducive credit environment in a bank, as there is no consolidation of a major line of credit in a few hands. PVBs prefer a more diversified credit disbursement system, which mitigates default risks.
●Asset Quality Management: Asset Quality Management refers to the valuation of credit-related risk. It is observed that Asset quality is comprehensively better in PVBs. It can be inferred that PVBs have rigorously implemented the Credit Risk Management Principles laid down by the Basel Committee on Banking Supervision. PVBs have been consistent in assessing credit-related risks, which has enhanced their asset quality.
Recovery Policy
Banking companies in India have consistently failed to recover bad loans. It is observed that the loan recovery mechanism in the PVBs is more efficacious than in the PSBs. PVBs like HDFC, Kotak, and Federal Bank, have successfully maintained their Net NPAs lower than 1.5% in the Financial Year 2021 through their loan recovery architecture. In today’s time, PVBs have created robust risk control units and third-party review systems to engage in an effective form of monitoring and recovering credit. The post-disbursement supervision of PVBs is strict and highly efficient, which has evidently resulted in lower NPAs.
Privatisation of PSBs - A Reality Check
One cannot deny that historically, PVBs have outperformed the PSBs in terms of containing the growth of NPAs, and they continue to sustain this position. But can the statistics of better performance of PVBs in stabilising the NPAs be a sufficient reason to pursue the privatisation of PSBs in India? While it is true that NPAs could severely affect the health of any financial institution, they cannot be the sole criterion. In fact, contrary to popular opinion, several studies suggest that State ownership of Banks has proved to be more beneficial for the holistic economic development of the country.
In this context, it is pertinent to discuss the arguments against the privatisation of banks. Firstly, studies suggest that post the 2008 GFC, several developed and developing countries found it imperative or rather necessary to nationalise the stressed banks of their countries for greater macroeconomic resilience. Secondly, State ownership of financial institutions was found to be strongly associated with effectively addressing market failures and improving general economic welfare in the country. Thirdly, studies found that the general trajectory of lending by PSBs was rather countercyclical or less procyclical, as opposed to the predominantly procyclical fiscal policies of the PVBs. Such a trajectory reveals how PSBs promote macroeconomic stability in the country. Fourthly, PSBs were also found to promote general public welfare (through PSL or otherwise) and financial inclusion in the country. Lastly, studies suggest that in times of financial crises, PSBs played a crucial role in preserving public confidence, stabilising the economy and preventing financial disintermediation. Hence, unreasoned privatisation of PSBs for stabilising the NPAs and simultaneously promoting the economic welfare of the country is not a viable proposition. The objectives, interests, and responsibilities of PSBs and PVBs vary and so does their performance. Nevertheless, studies suggest no significant difference in the profitability of PSBs and PVBs.
Conclusion
The debate about the privatisation of State-Owned Banks is not new. The performance of PSBs and PVBs has been fairly competitive. However, the PVBs seem to have outperformed the PSBs in terms of stabilising the NPAs due to their profit-oriented and efficient credit risk management system - extending credit to more stable sectors, diversifying credit disbursement and asset quality management. Besides, the robust credit recovery mechanism of the PVBs has aided them in the same.
Despite the success of PVBs in stabilising the NPAs, it would be myopic to consider the privatisation of PSBs for the sole objective of containing the NPAs. One must appreciate that the PSBs hold greater responsibilities, including but not limited to advancing credit to stressed sectors of the economy, pursuing countercyclical fiscal policies to maintain macroeconomic stability, promoting general public welfare and financial inclusion, and preventing financial disintermediation.
Even after having such additional responsibilities, PSBs have shown significant resilience, both domestically and internationally, despite the 2008 GFC, the COVID-19 Pandemic, and the Russo-Ukrainian War. Apart from these considerations, one must bear in mind (i) that India is still a developing country, (ii) that the Constitution under Article 38 provides that the Government shall strive to promote the welfare of the State, and (iii) that the global financial system tends to advance financial disintermediation, despite the diligent supervision of the RBI. Therefore, while PVBs offer noteworthy lessons for managing NPAs, privatisation cannot be adopted hastily by PSBs, given the inherent differences between PSBs and PVBs. Additionally, privatisation, besides being an incomplete and piecemeal solution, must be implemented gradually, strategically, and prudently if adopted by PSBs. Moreover, no country can afford the absolute privatisation of its financial institutions.
Discussion and Suggestions
It is established that gradual privatisation of PSBs can only serve as a long-term strategy. Moreover, privatising banks beyond 50% may pose a direct threat to national interest and sovereignty, considering India's history of colonisation, usury, and the necessity for bank nationalisation since Independence. In this context, it is pertinent to discuss a holistic set of potential strategies and steps that PSBs and other stakeholders can take to improve the financial health of PSBs, beyond the myopic scope of privatisation.
Stress Management Practices: PSBs can address the NPAs by implementing effective stress management practices. Firstly, they must conduct thorough stress tests to identify vulnerable loans. Secondly, they may restructure loans and offer moratoriums to struggling borrowers, providing them with breathing room to recover. Thirdly, PSBs can collaborate with asset reconstruction companies to offload stressed assets. Lastly, enhancing transparency in loan disbursement and adopting stricter monitoring mechanisms can prevent future NPAs.
BASEL IV - Crisis Management: With countries such as the US and EU planning to adopt Basel IV or Basel 3.1 by 2025, it is imperative for India to consider adopting risk management suggestions to enhance its crisis management capacity. Basel IV establishes an “output floor”, which prevents a bank’s internal risk exposure calculation from dropping below 72.5% of the standardised method. Such a measure can limit a bank’s credit risk during stressed economic situations.
RBI and Banking Oversight: To address the challenge of NPAs in PSBs, the RBI holds the power to bolster banking policy and supervision by several means. These include strengthening the enforcement of Prudential Norms through enhanced penalties for non-compliance, implementing more stringent Prompt Corrective Action (PCA) measures with clear thresholds and quicker triggers to prevent/curb NPA escalation, and conducting periodic and frequent Asset Quality Reviews (AQR) to ensure timely identification and provisioning for NPAs.
Government and NPAs: The Government also plays an integral role in influencing the financial health of PSBs and addressing NPAs. It can contribute to NPA containment through various measures. Firstly, by addressing operational inefficiencies to ensure prompt resolution under the Insolvency and Bankruptcy Code (IBC). Secondly, promoting negotiation, mediation, and non-adversarial dispute resolution mechanisms could aid in managing NPAs effectively. Thirdly, combating white-collar crimes such as fraud, embezzlement, and misappropriation of banking funds is essential, given their contribution to the poor financial health of banks. The Government must enhance regulatory oversight, impose stricter penalties, promote transparency, and implement robust risk management strategies to prevent and detect such crimes. Fourthly, promoting transparency is another crucial aspect where the Government's focus should lie, steering away from schemes like electoral bonds, which could foster corruption and cronyism, potentially exacerbating NPAs. Lastly, the banning of irrational freebies is imperative as these strain government finances, leading to increased borrowing and fiscal deficits, indirectly impacting public sector banks by diverting resources from productive investments, potentially constraining their capital adequacy and contributing to NPAs.
Balancing Public Welfare Objectives: PSBs play a pivotal role in promoting public welfare through financial inclusion and intermediation, extending credit to underserved borrowers and priority sectors. However, this practice significantly heightens the risk of NPAs by exposing PSBs to market volatilities. Furthermore, PSBs may relax credit underwriting standards to accommodate borrowers with limited creditworthiness, potentially straining operational efficiency and risk management capabilities. Hence, PSBs must balance these goals with prudent risk management, requiring robust credit assessment, monitoring, and resolution strategies.
Internal Management: One of the primary concerns with the rise in competition in the banking sector is attracting corporate borrowers by advancing loans without sufficient due diligence. By implementing strong corporate governance practices, banks can enhance transparency and accountability. Internal checks and balances help detect and prevent fraudulent activities. Establishing a robust internal policy for credit risk, asset quality, and recovery enables banks to identify potential bad loans and address deteriorating assets.
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