In good times, bad loans


  • Tracing roots of rise in Non-performing assets (NPAs) in India.


Some facts

  • Gross Non-performing Assets (NPAs) of banks rose to Rs 10.3 lakh crore in FY18, or 11.2% of advances.
  • Banks wrote off a record Rs 1.44 lakh crore of bad loans in 2017-18.


About NPAs

  • A Non-performing asset (NPA) is defined as a credit facility in respect of which the interest and/or installment of principal has remained ‘past due’ for a specified period of time.
  • In simple terms, an asset is tagged as non-performing when it ceases to generate income for the lender.
  • NPA is used by financial institutions that refer to loans that are in jeopardy of default the so called NPL.
  • Once the borrower has failed to make interest or principal payments for 90 days the loan is considered a non-performing asset.
  • Non-performing assets are problematic for financial institutions since they depend on interest payments for income.
  • Troublesome pressure from the economy can lead to a sharp increase in NPLs and often results in massive write-downs.


Roots of NPA’s in India

  • In the years just before the collapse of Lehman Brothers and the global crisis, India saw a boom.
  • The strong growth of 2006-08 triggered an ‘irrational exuberance’, in which lay the seeds of many of today’s NPAs.
  • The growth in NPA’s can be attributed to the RBI’s Policy trillema.


RBI’s Policy trillema

  • The impossible trinity or ‘policy trilemma’ derives from the Mundell-Fleming model, which holds that a country cannot at the same time have monetary policy autonomy, a fixed exchange rate, and free capital movement. It has to choose any two of the three, hence the trilemma.
  • The central bank was trying unique ways to manage the ‘impossible trinity’, a challenge that countries across the world during global crisis have struggled with.
  • India, a developing economy wanted:

                1) Capital

2) An exchange rate that favours exports

3) Monetary policy independence to keep a check on inflation


Capital reqiurement

  • Capital flows to India were rising steadily from the early 2000s onward.
  • From $17.3 billion in 2003-04, net capital flows jumped over six times to $107.9 billion in 2007-08.
  • Despite measures to deal with capital flows, India could not control this surge, and RBI intervened to sterilise, or sell, government bonds in its stock.
  • But the RBI ran out of its stock of government bonds by 2004, and had to issue fresh paper called market stabilisation scheme bonds.
  • This brought fiscal costs to the Finance Ministry, which had to pay interest on these bonds and hence the ministry objected to it.


Monetary policy independence

  • Given rising interest expenses and the Ministry’s objections, RBI could undertake only partial sterilisation post 2004, which led to compromises in monetary policy autonomy.


Favourable exchange rate

  • The massive inflows would have lead to a sharp appreciation of the rupee but instead of allowing the exchange rate to fluctuate based on market forces, RBI intervened heavily in the foreign exchange market by purchasing excess dollars, leading to an accumulation of reserves. so, The RBI kept the exchange rate rigid, at a time when capital flows surged.
  • This helped avoid any adverse impact on exports, on the back of which the Indian economy rode and posted growth rates of 8-9 per cent.


Consequences of the above Monetary policy trillema

  • India’s attempt to manage this trilemma had limited success and some unintended consequences.
  • Since only partial sterilisation was possible through the issue of MSS bonds after 2004, the banking system was left with significant rupee liquidity.
  • The quantity effect ensured that the pricing remained low.
  • This spilled over into monetary policy interventions, which kept interest rates low and laid the foundation for a credit boom during 2004-05 to 2007-08.
  • Besides, the past experience with infra projects that were completed on time and within budget, encouraged banks to lent heavily.
  • Lending by banks to industry (excluding individuals, agriculture and Food Corporation of India) jumped 30-35% year-on-year during this period, making this boom the biggest in 25 years in India.
  • Credit growth could not be stopped; it would have been detrimental to growth.


Factors contributing to NPAs

  • The high credit growth as discussed above along with other factors led to huge rise in NPAs.
  • The RBI had to balance multiple objectives: regulating banks, reining in inflation, managing government borrowings, promoting growth, and ensuring financial stability.
  • Enormous faith was being placed on the due diligence capabilities of banks, and there was a general belief that the prudential norms of banks were foolproof. However, this proved to be wrong.
  • A large number of bad loans originated during 2006-08 when growth was strong.
  • The credit boom, and the phase of irrational exuberance, is a problem that pre-dates Lehman, but the jolt of the financial crisis, the fiscal policy mistakes that followed, poor coordination among regulators, and the wrong lessons learnt, continue to dog India.


Way forward

  • Banks and promoters have to strike deals outside of bankruptcy, or if promoters prove uncooperative, bankers should have the ability to proceed without them.
  • Bankruptcy Court should be a final threat and much loan renegotiation should be done under the shadow of the Bankruptcy Court, not in it.
  • We need concentrated attention by a high level empowered and responsible group set up by government on cleaning up the banks.
  • It is very important that the integrity of the process of identification of bad loans be maintained, and bankruptcy resolution be speedy.
  • Given the conditions, the promoter should have every chance of concluding a deal before the firm goes to auction, but not after.
  • Higher courts must resist the temptation to intervene routinely in these cases, and appeals must be limited once points of law are settled.

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