As I write this article, the USD 1.5 trillion Indian banking sector is facing an unprecedented amount of pressure owing to non-performing assets. To call the situation serious will be an understatement. Maybe alarming is the correct word for it. While there is a lot of chatter on the media about it, the magnitude of impact the current NPA problem can potentially have is probably yet to dawn on public consciousness. For most people on the street and certain news channels, India’s NPA crisis begins and ends with a certain gentleman called Vijay Mallya. As tantalizing as the entire Mallya saga may sound, it is not even the tip of the iceberg when it comes to the woes of the Indian banking sector. While most of the chatter has been around public sector banks, I call it a crisis of the banking sector as a whole because the public sector banks account for more than 70% of the nation’s banking sector and their NPAs constitute more than 90% of the overall.

Till about year 2008 – 2009, the NPA pack was always led by private lenders. The first time the public sector banks came to the NPA forefront was in 2009 when they overtook the likes of ICICI Bank. Even the biggest supporter of the Congress and UPA would agree that the second UPA regime was characterized by dwindling economic growth. By the year 2010, most companies were facing tremendous pressure from delayed revenue realization from their capex investments.  The worst affected were the turnkey infrastructure firms with the ever increasing challenges of delayed revenue recognition. Throwing caution to the wind, between 2010 and 2013, the banks between went on a tizzy doling out loans to corporates irrespective of the credit perception. A part of it was fueled by irrational exuberance regarding the fortunes of the Indian Economy.  Just to give you an idea, a lot of these loans were taken by companies with operating income less than their previous interest obligations and the companies saw these loans as a way to stay afloat. The other part of was because the PSU banks got engaged in a pure volume game with one another to ensure bigger though not always better numbers were reported every quarter. The government often treat the public sector banks as an extended arm of their public policy and the banks inadvertently become party to a lot of government’s populist agendas such as debt forgiveness programs. It is understandable why the government of the day would have turned a blind eye to credit perception in favour of making more money available to the corporates in the hope of stimulating a slowing economy. As a consequence, the NPAs of banks rose nearly 300% between 2009 and 2014.
While the genesis of the problem may have been due to indiscriminate lending without caring two hoots about due diligence and credit perception, what turned the problem into a crisis however was the way the banks were recognizing NPAs and their tendency to hide them. The banks in order to make their balance sheets look better tend to restructure a lot of their stressed assets or loans which are near default instead of declaring them as NPAs for write off. The irrational rationale behind doing this was banks don’t need to provision for stressed loans but they need to for NPAs. The biggest problem with this however is that a restructured loan usually ends up becoming NPAs anyway thereby prolonging the inevitable. The under reporting of the NPAs turned a disease which was malignant to chronic and eventually acute.
The tipping point came however from the Reserve Bank of India under the aegis of Raghuram Rajan. The RBI, sensing a tremendous underreporting of NPAs had asked the banks to declare their stressed assets to the RBI. Based on an asset quality review, the RBI gave guidelines to banks to declare significant portions of their stressed assets as NPAs. All of a sudden the dirty linen was in full public view.
So how big is the NPA crisis and why should we be very worried? On last count, the banks so far have been willing to disclose that USD 131 billion, or about 14% of their total lending. If a recent Credit Suisse report is to believed, the final amount may go up USD 36 billion more making the NPAs close to 18% of the total lending by the time the audit ends on March 31st. The numbers are alarming to say the least. The banks need to “provision for” or set aside money to cover bad debts so that the retail deposits remain safe. This causes an increased capital requirement for PSU banks. Now since the government is effectively the owner of the PSU banks, the burden of providing capital adequacy comes to the ordinary tax payers. Currently the banks have provisions covering only 60 to 70% of the bad debt which is woefully inadequate and they are in dire need of recapitalization. Can the situation get any worse? Certainly! There is legitimate concerns that the RBI audit may not be stringent enough! For example, currently only 10 to 20% of the loans given to the metals sector has been classified as bad debt but almost 86% of the metals industry loans are highly stressed. Hence, the numbers can rise significantly.
What is the way forward to remedy the situation from getting any worse and preventing a wider systemic collapse? The RBI has given the banks time till March 2017 to clean up their balance sheets but that is still some distance away. The pressing need of the banks is recapitalization for provisioning and compliance with Basel III norms.  To maintain the Common Equity Tier 1 requirements corresponding to the credit growth, which is around 10%, the banks will need USD 40 billion in additional capital. This number again can increase very quickly. The government has already promised a capital infusion of INR 25,000 crores as equity in the budget. The RBI has also eased rules allowing lenders to consider reserves associated with property revaluations and foreign-currency translations as Common Equity Tier 1 capital. This has a potential of freeing up close to USD 8 billion in capital for the banks. The biggest irony is, if the economy sees a turnaround characterized by demand for credit, as the Modi government is hoping, the capital requirements will only increase further. Besides, the rate of recognition of NPAs is significantly higher than the rate and magnitude of capital infusion thereby creating a mismatch which can further add to the woes. Having said that, there are a number of weapons in the government’s arsenal. Firstly, the capital needs could be lower if there is restructuring and dilution of government stake-holdings in public sector banks which are currently between 65% and 80%. Secondly, the RBI has ample ways and means of raising or financing the capital if required. On the longer run, consolidation will be required. Hence, even though there is a crisis, there is no reason to panic. Needless to say the situation will require some deft handling by both the RBI and the Government of India.
Raghuram Rajan was more than apt when he said that disease ailing the bank require “surgery” and not “band aid”. The cure will be long and painful but at the end of it, hopefully the banks will emerge squeaky clean once again. And when we have weathered the storm, the government needs to address the key issue which caused this in the first place, the issue of governance of the PSU banks. For the time being, I am keeping my fingers crossed, and considering what is at stake, so should you!