From bad to worse

The NPA crisis needs market-based solutions

In its Financial Stability Report (FSR) released on Tuesday, the Reserve Bank of India (RBI) insisted that India’s financial system remained stable overall. But the prognosis for the bad loan crisis should cause policymakers to worry. The FSR predicts that, if the prevailing macroeconomic environment stays the same in the coming year, the ratio of gross non-performing assets (NPAs) to total loans and advances will rise to 12.2 per cent in March 2019, an increase of 60 basis points over the figure for the end of the financial year 2017-18. This would be the highest since 2000, the last time India was faced with a banking problem in the wake of the Southeast Asian crisis. Of course, if the economic situation turns adverse — perhaps due to global factors — the gross NPA ratio would rise further, to 13.3 per cent in March 2019. For public sector banks (PSBs), which are the locus of this current crisis, the gross NPA ratio would be 16.3 per cent in March 2019 under current circumstances, and 17.3 per cent if things get worse with the macroeconomy. For six banks subject to the RBI’s prompt corrective active (PCA) framework, which limits their functioning, the capital adequacy ratio would dip to 6.5 per cent in March 2019, below the 9 per cent regulatory mark. Banks with exposure to infrastructure, gems and jewellery, cement, and engineering are particularly in danger.

It is clear that, contrary to expectations in some quarters, the NPA crisis is not going away. Nor are current plans for the recapitalisation of PSBs likely to be adequate once all is said and done. While the new insolvency and bankruptcy code has taken great strides over the past year, it is also clear that it cannot yet be declared a success in terms of overcoming the current crisis. The FSR points out that only recently have financial creditors — meaning banks — taken to using the new insolvency process. Of the 701 cases admitted by the National Company Law Tribunal, only 176 have been closed — of which only 22 have been resolved. The government’s current approach appears to be to seek regulatory forbearance where possible, and to rely otherwise on existing recapitalisation schemes and the insolvency process. 

But given the growing magnitude of the problem, a more systemic approach is needed. The only sustainable solution remains governance reform in the banking sector. The RBI’s prompt corrective action framework is all very well, but the hope that PSBs subject to PCA will somehow return to business-as-usual must be accepted as a fiction. Nor can a bad bank, which seems to have found favour again in the Union finance ministry, be seen as a solution. It may be politically unpalatable in an election year, but the government must seek out more permanent solutions to the problem of PSBs — which, the FSR points out, are also more prone to fraud. Market-based reform must be the priority. The central message should be that all banks will eventually be subject to market discipline or they will be closed or otherwise rendered irrelevant. Till that happens, the government should consider converting some of the worst performers among PSBs to narrow banks, which won’t lend at all and therefore carry virtually no credit risk.