Why Npas Are Not Just About Bank Governance

Why in News?

• The article probes the links between twin balance sheet crisis and external commodity shocks that could lead to a better understanding of the non-performing assets (NPAs) problem in India.

 

Background

• Vicious NPA cycle: During the mid-2000s, the Indian economy was booming, where GDP annual growth hovered around 9-10%. With corporate profitability at its highest, India Inc. launched massive projects worth lakhs of crores and were riding on huge amounts of debt, mostly financed by banks.
  • By 2007-08, the investment to GDP ratio reached almost 38% and the amount of non-food bank credit doubled from 2004-05 to 2008-09. By the late 2000s, NPAs (as a percentage of gross advances) had decreased to less than 3.5 per cent.
• Coupled troubles: However, following the global financial crisis, growth and revenue projections fell and finance costs went up due to higher interest rates, resulting in stress on the books of both corporates and banks.
  • Hence NPAs began to rise in 2011 and peaked at 11.18 per cent in the fiscal year that ended in 2018.
  • This twin balance sheet crisis contributed significantly to the deceleration of growth in the late 2010s.

 

Definitions

• Non-Performing Assets: In most cases, debt is classified as non-performing, when the loan payments have not been made for a minimum period of 90 days.
• Twin balance sheet crisis: A twin balance sheet is a scenario where banks are under severe stress and the corporates are overleveraged to the extent that they cannot repay their loans.
  • The Economic Survey of 2017-18 explained that twin balance sheet problem follows a standard path.
  • The companies expand during a boom, leaving them with obligations that they cannot repay. So, they default on their debts, leaving bank balance sheets impaired, as well.

 

Imprecise grounds cited for NPA rise

• Governance issues: Poor management in public sector banks stemming from government ownership has been cited as the major causes of the NPA crisis.
• Wrong narrative: The government ownership does not explain the improvement in performance that public sector banks saw throughout the 2000s.It is improbable that governance improved suddenly (late 2000s) and dwindled subsequently (2011-18).
  • Moreover, most of these NPAs arose due to defaults by private sector non-financial firms, making it even more difficult to accept the blame that’s been put on governance issues.
• Distinct business models: A careful examination of the data gives overwhelming evidence that a large fraction of the difference between NPAs in the public and private sector banks arose due to differences in their business models.
  • In early 2010s, public sector banks had significantly higher exposure (per cent of total loans) to commodity-sensitive sectors such as iron and steel and textiles compared to private sector banks.
• Price decline: The rise in NPAs from 2011 onwards coincides with the fall in international commodity prices.
  • The public sector banks generally had higher exposure to commodity-sensitive sectors; hence they experienced a relatively higher decline in prices and a bigger rise in non-performing assets after the price crash of the 2010s.
• No NPA stress despite pandemic: It is because of the commodity price boom in the last two years that despite the worst kind of economic crisis due to Covid-19, hardly any stress in the banking sector during the pandemic is heard.
  • Statistics: According to the Reserve Bank of India’s latest financial stability report, gross non-performing loans (GNPAs) of the banking system have declined from 7.4 per cent in March 2021 to a six-year low of 5.9 per cent in March 2022.

 

Commodity prices and NPA linkage

• Description: The close link between commodity prices and non-performing assets works via the worsening of profitability of non-financial firms which, in turn, makes them default on loans. It can be seen as follows:
• Demonstration: A decline in commodity prices leads to a decline in raw material costs but it also leads to a more than proportionate decline in sales revenue.
  • And that, combined with fixed labour costs, crunches the margins of these firms and their loan repayment capacity.
• Real scenario: A large number of borrowers in commodity-sensitive sectors faced this situation during 2011-16 when the non-energy commodity prices declined by about 35 per cent and metals prices declined by 45 per cent.
  • This large adverse movements in prices, compared to the projected prices in 2010 and before, on which business decisions were made caused higher corporate default.
  • Hence, banks exposed to commodities whose prices declined, experienced a higher build-up in NPAs compared to banks not exposed to these sectors.

 

Calibrating price movement effect on NPAs

• Mixed bag: As banks lend to several sectors with heterogeneous price movements, the estimation of the effect of movements in prices on NPAs becomes slightly difficult.
• Benchmarked index: To overcome this, nominal price index has been created using novel data on bank’s sectoral exposure (percentage of loans to a sector) and commodity prices.
  • For each bank, the exposure is multiplied with the sectoral price in that year and added up over all the sectors to obtain the nominal price index.
  • This nominal price index is distinct for each bank every year and captures the bank-wise heterogeneity in exposure to the commodity prices.
• Estimating NPAs by index: This nominal price index can change due to changes in exposure to sectors or changes in prices associated with these sectors.
  • The impact of changes in commodity prices on NPAs is estimated by allowing the nominal price index to vary due to prices alone.
  • The banks which experience a higher decline in prices are also found to experience higher amounts of defaults and hence higher NPAs.

 

Ramifications of aforementioned findings

• It helps us decipher the twin balance sheet crisis of the 2010s which affected growth adversely and has not been understood so far.
• A large proportion of NPAs arose because of exogenous shocks, which have nothing to do with management and governance issues in public sector banks.
• The authors believe that these findings will drive more systematic research in this area which will lead to a better understanding of the twin balance sheet crisis of the 2010s and inform our way forward for appropriate banking reforms.

 

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Source: Why Npas Are Not Just About Bank Governance