NPAs – Isn’t Prevention better than Cure!

The large and increasing levels of Non Performing Assets of the Indian banking industry has been hogging headlines for quite some time now, and there seems to be no end to the saga. To manage and contain this problem academicians, policy makers, RBI, and the Government have come up with various solutions with the insolvency code being the latest kid in the block. 

The proximate reasons for phenomenal increase in reported non-performing assets (NPAs) over the last three years, is not change in economic conditions or wilful defaults. It is simply because we had a strong regulator who insisted that banks follow the laid down, internationally accepted norms for recognizing NPAs – the so called Asset Quality Review. Otherwise, it would have been business as usual till one fine day the banking system would have simply collapsed and taken the real economy (and all of us too) along with it!

Any solution to a problem needs to first look at the reasons as to why the problem has arisen. Let us do the same for our “NPA” problem!

A manufacturing organisation makes physical products – say cars, or detergent, or steel utensils etc. To ensure consistent production of goods of high or at least acceptable quality they set up quality control systems which encompass design of appropriate manufacturing processes, quality control of their raw material or sub-assembly suppliers, correct operation and control at each stage of the manufacturing process till production of the finished product. For achieving consistently good quality products it is therefore essential for the quality control mechanism to be functioning well throughout the production process.

Similarly, one of the key functions of banks is to continuously produce good quality loans & advances. By good quality, it means loans which are remunerative and have low probability of default. From this perspective, the incidence of high and growing levels of NPAs in the Indian banking system is akin to a manufacturing organisation making a larger than acceptable level of defective products.

The production process used by banks to ensure that consistently good quality loans are made consists of making a series of appropriate judgments or decisions for which banks need to have, inter alia, an appropriate conceptual framework for lending, selecting suitable people with the required skills, giving them adequate and suitable training, understanding how or why credit risks arise and having clear laid down credit risk  management policy, having a suit of loan products which are in line with the requirements of the potential borrowers and the risk capabilities of the bank, a not too cumbersome loan documentation process (this is extremely tricky since workable debt contracts are far from complete contracts!), monitoring the loans once it is made, and taking corrective action as and when required, entrapping the cash flows etc. All these taken together would ensure a high probability that the loans & advances made are repaid on time and on the terms agreed at the outset.  Failing which, banks have to have sound processes for recovering loans which go bad inspite of taking all possible measures earlier.

Now for banks to be able to take sound decisions it is essential to create a governance framework which encourages and nurtures independence and professionalism. Something which is just not engendered by having RBI, GOI, vigilance departments, criminal investigations, and courts micro-managing how banks perform their work and breathing down the necks of bankers 24 by 7. One result of such micro-management is the extremely voluminous loan appraisal notes prepared by banks. This detracts focus on the nature, quality and key risks of the credit while protecting all the people involved in the decision making process from any adverse outcome. The consequence is extreme delays in decision making and no clear cut indicators on accountability. In practice, ultimately the most helpless lowest level official, who has no support of the union or political support of any kind who ends up facing the music. This in turns leads to decisions being based on all kinds of extraneous reasoning which have little to do with the borrower and the credit risk. Appraisal notes running into 100 – 150 pages is the norm. I really wonder as to what kind of reasoned decision taking can take place under such circumstances. 

I would like to give another small (and totally unrelated to present discussion on NPA management) example of micro-management by RBI. For anyone doing any kind of business, the base level understanding is that they should know their customer. Even a doctor evaluates his patients on parameters others than strictly medical, say on socio-economic parameters, before prescribing any line of treatment. Now banks have to follow a strict and detailed KYC norms prescribed by RBI (which is also extremely difficult to comprehend). Are our banks and bankers so incompetent that they are unable to properly and correctly evaluate their customer?

Having nearly 70% of our banking system in the public sector has had another extremely adverse effect – the virtually complete absence of creativity and innovation. The closed, one size fits all framework for recruitment, promotions, pay-scales, to the extremely outdated and dysfunctional conceptual system under which most lending and monitoring is done, and the identical Core Banking System has left little room for experimentation and innovation, or growth. After all only open systems can hope to achieve negative entropy! Public sector does not automatically mean lack of professionalism and accountability, provided governance systems enable and nurture it. In this regard the continued interference of DOB, MOF with its natural consequence of politicization of decision making at all levels is a key factor and needs to be addressed forthwith. Any change for the better would have to start from here.

On the conceptual framework of lending in India, a couple of issues are extremely critical. First, the dichotomy on working capital versus term lending is not only artificial but also misleading. For the lender there should be only one focus, the debt servicing ability (both quantum as well as volatility) of the borrower and mechanisms for entrapping cash flows. No borrower can service its debt (which is the same as no lender can expect recovery) by recourse of foreclosing just either the working capital assets or the long term assets – or even both. For debt to be serviced the sine quo non, which is invariably missed out, is a functional borrower which can be expected to continue indefinitely as a going concern and create economic surpluses. Second, the single minded focus on security in lending misses on the nature of risk – whether the risk being assumed is in the nature of a debt risk or an equity risk – resulting in mispricing of the risk. An experience through which all of us have lived for more than 30 years are our DFIs. They were taking exposures on a portfolio of assets where their risk was essentially equity / quasi-equity in nature while their returns were wholly debt related. It is natural that the returns from such a portfolio would be sub-optimal. The main culprit here was equity risk premium, not sloppy appraisal or monitoring or the biggest bug-bear of all of us – corruption.       

The idea of having a “bad bank” is very much workable, if and only if, the reasons for proclivity of Indian banks to continuously create NPAs is first sorted out. The capital requirements can be fairly easily be met even for transferring entire reported NPA level of Rs.10 lakh crores. First, the bad bank need not take over the entire NPAs at book value. They can very well take it at a discount of say 10% of the book value with agreement to share any surpluses in recovery over a certain minimum. That would reduce the total capital requirement to Rs.1 lakh crore. Second, banks typically function at a Capital Adequacy Level of about 12%. As such the equity required to fund holding Rs.1 lakh crores of assets would only be around Rs.12,000 crores, with the balance funded through debt. This equity be funded on 50:50 ratio with GOI picking up Rs.6000 crores and the banking industry taking over the balance Rs.6000 crores. The balance capital requirement could be met through debt from the banking industry itself specially if such debt were guaranteed by GOI and qualify as SLR investment.

Keeping NPAs low for banks is critical for various reasons. First, NPAs deliver a double whammy to the bottom line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans. Second, banks being highly leveraged entities have much lower room to manoeuvre fall in operating margins, something rising NPAs result in. As such, it is important that actual NPA levels be monitored regularly and closely, otherwise they start making losses. Third, by affecting ability of banks to provide loans as well as liquidity services to the real economy (since the quantum of lending / funds available to grease the economic system with banks is exponentially inversely proportional to rising NPA levels) the income and employment opportunities in the real economy start getting curtailed (rather drastically) with rising NPAs in the banking industry. Finally, banks maintain the institutional memory of credit history of all the actors in the real economy in their records. It is very hard and expensive to recreate this information once lost. When NPAs become so high that a bank becomes bankrupt and has to be closed down, this memory is as good as lost forever. This in turn leads to a break in the payment cycle to and from the various players in the real economy, which in turn hits the real economy hard by drastically reducing both income and employment opportunities in the economy. These are the primary reasons that no society (or its government) can afford even the smaller banks to close down, leave alone the big ones and making managing NPA critical for our collective well-being.

On the Functioning of Financial Markets

The article, “The Jan DhanYojana, four years later” in The Hindu dated 29^th May 2018  though topical, and containing a few hard facts and figures, does not do justice to this very important subject and is way off in some of its conclusions. I will try and justify my contentions in this monograph. Please have a little patience.

Financial Inclusion is not just about opening bank accounts, using these accounts, and providing access to formal credit. To appreciate the importance of the concept of Financial Inclusion one needs to step back and see why and how strong, stable, and inclusive financial systems (banks and other financial intermediaries, finance companies, cooperative credit societies, capital market institutions etc. along with a strong regulatory framework) are essential for steady, accelerated, and equitable economic growth.  There is extensive literature on the subject starting from the 1960s, especially seminal ideas propounded by Gurley, Shaw, McKinnon et al. 

Naturally, for an inclusive financial system, all or most citizens need to be involved and be part of it. For example, people need to be able to ride the Bullet Train if they are to benefit from it. Just watching it whizzing past is not going to be of much help to either the people who built the Bullet Train, those who operate it, or the general public!

Developed and well-functioning financial systems, inter alia, (a) enable users to reduce the cost of exchanging real resources ie, through elimination of rigidities and reduction in transaction costs through both economies of scale and scope and use of technology by the financial intermediary; (b) leading to more efficient resource allocation, (c) provide the backbone of the payment mechanism, (d) helping to distribute and reduce risk for users (through tenor transformation, portfolio diversification, better monitoring through specialized skills etc), (e) enable easier accumulation of short & long term surpluses, (f) balance savings with need of funds over lifetime changes etc.  

Now starting with saving mechanisms, for any user of financial savings product (such as a JDY account) it should be safe, convenient, reliable, and cost effective. If a person has to spend half a day (that may mean losing a full day's earnings) to go to the bank to deposit or withdraw money he or she would obviously not use the facility. Add to that the paperwork in opening and operating the account. Or the transaction costs for small value receipts / payments using app-based software.  From the bank's point of view, transaction costs for servicing small accounts tend to be rather high and are naturally neglected - it just does not make commercial sense. Furthermore, if there aren’t steady and regular interactions between the intermediary and its customers, no trust based relationship can be built up leading to its eventual atrophy. 

The authors mention that 48% of bank holders have not done a single transaction during the past one year. This statistic by in itself hides the fact that there are have been reports of bankers putting in paltry sums of Rs.1 to Rs.10 in JDY accounts to show some transactions and lower number of zero balance accounts!¹

As far as penetration of JDY accounts are concerned, the statistic that 80% of adults having bank accounts level mentioned in the article may need some scrutiny since the thrust of JDY is that all families should have functional bank accounts and the focus is not on individuals.

It also does not bring out the urgent need and pent up demand for savings mechanisms for small savers. In a study conducted by Stuart Rutherford²,  he discusses the service provided by Jyothi, a middle-aged semi-educated woman who makes her living as a peripatetic deposit collector in Vijayawada, whose clients are slum dwellers, mostly women. Jyothi has, over the years, built a good reputation as a safe pair of hands which could be trusted to take care of the savings of her clients. Jyothi’s accepted deposits of Rs.5/- every day so as to collect Rs.1100/- over 220 days. After which she returned Rs.1000/- to the depositor and retained Rs.100/- for her services. This translates to an annual negative interest rate of 30% per annum for rendering deposit services! Which I suppose is more than sufficient to make all our academics, policy makers, bureaucrats, politicians to start shouting Bharat Mata Ki Jai / Holy Marx / Jai Bhim or whatever and jump all over the place. But the fact remains that savers are willingly paying that kind of money since they value that service which the formal financial systems has failed to provide. Rutherford goes on to mention that slum dwellers in a neighbouring slum where there is no Jyothi at work actually envied Jyothi’s clients. Service providers for savings take different forms in our slums, villages, hamlets such as chit funds (formal & informal), Self Help Groups, and the numerous multi-level marketing companies which keep springing up from time to time all over the country.

All this springs from failure of our organized formal financial systems to provide such a service. The sad part is that this was not always so. Commercial bank’s did offer variations of something called Pygmy Deposits where deposit collectors made daily / weekly visits to collect the small savings and they provided this service without incurring a loss! For example, see the experience of Syndicate Bank discussed in Financial Innovations and Credit Market Evolution by V V Bhatt (EPW, Vol XXII, No 22, May 30, 1987). These were the days when banking operations were fully manual and as such the benefit of much lower marginal operating costs through use of digital technology was not available.

The thrust on promoting savings also does not take into account another critical aberration in our financial systems. Namely, due to widespread financial repression financial savings in formal institutions give a negative return in real terms! In this context, it is worth quoting the erstwhile Governor of RBI³ has gone on record in his speech wherein he mentioned that, “Many middle class savers value the high nominal interest rates on their fixed deposits, not realizing that their principal is eroding significantly every year”! Does that indicate as to why our society is subject to repeated onslaughts of Ponzi schemes all of which eventually and inevitably collapse. But during the course of their short existence promise an avenue for building up liquid financial saving which does not give negative returns in real terms.   And I am not even hinting on the effect of TDS on bank deposits which is extracted with clinical efficiency thanks to the superlative strength of Core Banking Systems.

Now let us see what happens in the absence of formal mechanisms for collecting small savings. They would have to be saved in kind since saving in cash would entail it losing value over time due to inflation if it was not lost, stolen, or borrowed away. If the saver managed to evade all these possibilities there is always the chance of it being spent on gambling or liquor. Saving in kind also has the added disadvantage of lacking fungibility and liquidity (the characteristics which gives fiat money its intrinsic value).

There also seems that there is another major and deep-seated myth among our academics and policy makers  -  that the poor do not and cannot have savings, or at least substantial savings. They need to appreciate that since earnings are highly variable and uncertain for the poor and they have absolutely no social security of any kind, savings are critical for survival. The small bits of savings is what enables the poor to survive from one misfortune to another. These savings take various interesting forms (again due to the failure of formal financial markets), such as, having reciprocal borrowing arrangements with friends and relatives, maintaining credit reserves with whom they provide services and products (by not immediately drawing down payments which are due), social practices such as neota, maintaining excess reserves of food grains and other items of inventory, keeping a few heads of goats, pigs, chicken etc which could either be sold or consumed as per dictates of circumstances etc.

This myth is also directly responsible for lack of attempts to design better savings mechanisms and for the stress on provision of credit as the proverbial magic wand for solving issues of “financial inclusion”.

Savers using the services of formal financial institutions like banks are cursed once again in another way. Since our bank’s are not making sufficient profits on the lending side of their business, they are naturally unwilling and unable to provide higher rates of returns on savings, especially in real terms! This suggests that the inefficiencies of the banking system and the borrowings from the formal financial sector are being subsidized by the deposit keeping community at large.

Now if one were to argue for promoting savings since it makes social sense,  one could also seek that the government should subsidize some portion of the operating costs – maybe through a reverse auction kind of mechanism. Banks could compete for achieving lowest cost for providing particular desired services, with the subsidy levels being based on this level. Since this subsidy would benefit society at large there would be much less scope for corruption. Otherwise banks will (and are becoming) become sick. Policies and practices which make banks sick will ultimately be of no good to either its customers or the economy. Continued good health of banks is essential for the real economy to remain robust - the reason they are so heavily regulated. Sick banks which have to be closed down also result in loss of institutional memory of the credit history of society, something which is impossible to recreate. For social and economic systems it is equivalent to heart failure in humans.

Technology may help in reducing transactions costs. Unfortunately, the system which has evolved over the last 30-40 years has resulted in traditional (PSU) banks lacking the requisite technical skills. Even worse, the one size fits all policy with industry wide equality in pay-scales, service conditions, internal processes, even the Core Banking System that they use, has stifled creativity and innovation. Something which is essential for growth of a vibrant financial system. An argument often given is that bank nationalization has enabled large increases in financial savings in the economy with its resultant positive effect on capital accumulation and economic growth. However, no one bothers to think about the cost of such savings mobilization – could the same levels of savings have been mobilized in more efficient ways, ie at lower costs?

The new generation pvt sector banks and the newest chips of the block - payment banks / small finance banks - either have too little incentives to pursue these market niches or are circumscribed by definition from benefiting from economies of scope, respectively!

Now coming to the stress laid on provision on easy access to credit, one needs to first appreciate that the ability or temperament to productively use credit is not very widely prevalent in any society. As such only a limited number of persons or families can benefit from access to credit. Furthermore, additional credit, cheap or costly, is no substitute for functional roads, primary health and education facilities, organized markets, or an administrative machinery which can prevent exploitative relationships. Even worse, there are well documented severe negative consequences in following a credit focused financial inclusion development strategy which include:

a)   Increasing levels of inequality in income and wealth since directed credit is cornered by the wealthy and politically powerful who thereby increase the capital at their disposal and become even more wealthy and powerful.  Larger loans means larger benefits, smaller loans means smaller benefits, and no loans means no benefits as far as the borrowers are concerned. And bulk of the people lie in the third category.

b)  Incentive to repay by borrowers who have preempted credit (typically through muscle or political power) is lower which not only further increases their economic and political status but simultaneously weakens the financial intermediaries who have lent the funds and have to book the consequent losses.

c)    Development of large and widespread corruption since the benefits are concentrated while the pain is widely spread, there is little focus or effort at tackling the resultant problems. Is it a wonder as to why our cooperative credit system produces some of our most corrupt politicians?

Another issue which hardly ever gets raised is the cost of capital. Interest rates reflect the cost of capital and it is well known that in India there is a very wide difference in the interest rates charged by most formal financial institutions / banks versus those charged by the fairly well organized informal institutions. The question that next arises is whether the informal sector is charging excessive rates or is the formal sector mis-pricing cost of capital.

Well interest rates in the informal markets are, prima facie, higher than formal markets. But would they still be considered higher cost after accounting for delays, the numerous trips, and the bribes with their associated real, direct and opportunity costs involved in accessing formal credit? The higher interest rates in informal markets also reflect the fact that (a) they are taking exposure to much higher risk levels, (b) provide kinds of services (other than credit) that formal intermediaries cannot even dream of, (c) have much less capital at their disposal as such require to charge higher rates to generate equivalent absolute amounts of return, (d) entire capital is in form of personal equity as such do not benefit from leverage (banks with Capital Adequacy Ratio of say 10% effectively have a leverage of  10:1) with its consequent benefits, and (e) during the slack season their capital is idle and does not generate any returns or meager returns.

Total cost of credit consists of basically two components, a fixed cost of accessing the credit which varies little with quantum of credit and a variable component, the actual interest rate. As such, for small value loans the average cost can be quite high since the fixed component has to be recovered from a smaller principal amount. This is another reason as to why informal lenders score over formal lenders, especially for small value loans and continue to be relevant. In this regard, Jerry R Ladman⁴ argues that “The partitioning of the market between BAB (a formal lender) and moneylenders shows the two lenders are providing different services. The moneylender provides credit quickly, on short-term basis, and in relatively small amount.”

Incidentally, the All India Rural Credit Survey (1951) (considered the gold plate for study of rural credit world-wide) does not support the prevalence of widespread use of exorbitant levels of interest rates commonly alleged to prevail in India! Data in this Survey indicated that village moneylenders grossed only an average of 11 percent per annum on their lending⁵!

Formal studies⁶ also suggest that the higher interest rates charged by the informal sector can be largely attributed to risks and administrative costs and not to monopoly power

Considering these factors, the conclusion arrived by most mainstream policy makers and the impression generally carried by most of us that informal money lenders are blood sucking thieves and rogues of the highest order seems not really substantiated by facts and logic. The reader may also care to remember that interest rates charged by many formal sector entities such as credit card companies and FinTecs involved in lending are not exactly cheap and more akin to rates charged by the informal sector.

Before concluding I would like to share a few quotes attributed to the ever-provocative Dale Adams, (Emeritus Professor of the Ohio State Rural Finance Program):

a)      "It is curious that the discomforts caused by a few people going into debt and not being able to repay tend to dominate general views held about financial intermediaries. The use of extreme cases to make general points is refined to an advanced art form in discussions about financial markets. Stories about poor farmers who lose their land to evil moneylenders are retold until people think that most loans go to default ….". (from Effects of Finance on Rural Development in Undermining Rural Development with Cheap Credit)

b)      … lenders provide loans, not gifts, and this creates obligations. When misfortunes strike, those obligations cannot always be met, putting the borrower into even greater jeopardy (from The Economics of Microfinance, by Beatriz Armendáriz de Aghion and Jonathan Morduch).

c)       … to the unwashed it (empowerment) conveys the impression that smearing a dab of additional debt on a poor woman will transform her into Super Woman. Those who insist on using this bloated term grossly overstate the contribution that indebting crusades play in easing poverty. More debt does not cure malaria or HIV/AIDS. It does not provide clean drinking water or prevent flooding. It does not improve law-and-order or eliminate weeds in a borrower’s crops. It does not make crops grow in barren soil or provide secure title to land that squatters occupy. It does not provide schools or teachers for the poor . . . (from The Economics of Microfinance, by Beatriz Armendáriz de Aghion and Jonathan Morduch).

There is much room for change / improvement in policy framework to enable our banks deliver on their capabilities. But such change should be based on an understanding of the nuances of functioning of financial markets and their main players such as banks. Propounding old, half-baked, hackneyed theories is not the way out – it is getting us into deeper mess.

1.   Government claims Jan Dhan Yojana was a big success. Here’s a reality check by Mayank Jain, The Scroll, 6th September 2017;  & Jan Dhan Yojana: One Rupee Balance and the Dormancy-Duplication Problem by Anuj Srivas, The Wire, 14/09/2017.

2.     The Poor & their Money, Stuart Rutherford, Oxford India Paperbacks

3.    Policy & Evidence.  Inaugural Address by Dr. Raghuram Rajan, Governor, Reserve Bank of India at the 10th Statistics Day Conference 2016, Reserve Bank of India on July 26, 2016, Mumbai 

4.    Ladman, Jerry R. Loan-Transaction Costs, Credit Rationing, and Market Structure: The Case of Bolivia, in Undermining Rural Development with Cheap Credit.

5.   All-India Rural Credit Survey, Vol. 1, The Survey Report, pt. 2, Bombay, Reserve Bank of India, 1957, pp. 490-91. - quoted by David H Penny in Rural Financial Markets in Developing Countries, page 66.

6.   Bottomley, Anthony. Interest Rate Determination in Underdeveloped Rural Areas, American Journal of Agricultural Economics 1975;

7.  Long, Millard F. Interest Rates and the Structure of Agricultural Credit Markets, Oxford Economic Papers 1968.