Understanding Bank NPAs

“Reserve Bank extends EMI Holiday” screamed the newspaper early in the morning of 22^nd November 2016, amidst those chaotic days of Rs.500 & Rs.1000 "demonetization". “RBI allows both individuals and firms with loans upto Rs. 1 crore an additional grace period of 60 days to repay dues”, said the paper.

...except that there was never any EMI holiday

“Demonetization: RBI gives small borrowers 60 extra days to repay credit”, said another - a leading financial daily, “…small borrowers who have been facing the brunt of demonetization, would get an additional 60 days to repay their credit, including agriculture and housing loans”.

Similar reports were carried by most newspapers that day, and repeated ad nauseum by television channels for several days thereafter. There was however one small problem – the news was completely wrong.

Most media houses wrongly reported the news

What RBI had said

What then had caused the press to report something like this, which wasn’t true at all? The answer to this lay in a circular issued by the Reserve Bank of India, put up on its website the previous day. The circular, titled “Relaxation in Prudential Norms”, said “…it has been decided to provide an additional 60 days beyond what is applicable for the concerned regulated entity(RE) for recognition of a loan account as substandard in the following cases…” and cited a wide gamut of loan accounts where this benefit will be applicable. Read the full circular here.

The operative term here is ‘additional 60 days…for recognition of a loan account as substandard’ which was misinterpreted to mean borrowers getting an extra 60 days to repay their EMIs or other dues. In fact, the RBI circular clearly mentioned “…this is a short-term deferment of classification…” and that this “…does not result in restructuring of the loans”. Shorn of its jargon, this means there is no change in dates when the borrowers have to repay, but if they do not, banks can have an additional 60 days to do what they do when the borrowers do not repay.

Understanding NPAs

News reporters and financial journalists aside, I have seen even analysts tracking the banking sector struggle with these terms. When banks give loans, the loans appear on the asset side of a Balance Sheet. A repayment goes on to reduce that asset, while a fresh disbursement increases these assets. However, not all loans get fully repaid, and occasionally a customer defaults. This leads to a capital loss for the bank, as the assets have to be written off. To an extent, such losses are considered ‘normal’ in the banking business, and prudence requires that banks prepare for them well in advance. This is where ‘provisioning’ comes in.

Provisioning means banks booking an ‘expense’ entry in the Profit & Loss account based on the expected losses arising from such defaults. Provisioning reduces reported profits of the bank and creates a capital buffer, which can be used when the losses actually occur. The amount of provisioning to be done is prescribed by the RBI, and depends on the ‘quality’ of the asset. The worse the quality, higher the provisioning, since lower are the chances you will ever recover your money.

Asset Classification

This is where ‘Asset Classification’ comes in. RBI requires banks to classify all loans in four groups – Standard, Sub-standard, Doubtful and Loss. Initially, all loans start as ‘Standard’. Assets under the other three categories are collectively called “Non-Performing Assets” or NPAs. NPAs are loans where principal or interest has not been received for more than 90 days beyond its due date. The RBI defines ‘Sub-standard’ as an asset which has remained an NPA for a period less than or equal to 12 months. After 12 months as an NPA, the asset degrades to ‘Doubtful’. ‘Loss’ assets are assets where the bank feels there is no hope of recovery from the customer at all. If an EMI was due on 5^th February 2017 and the customer failed to pay, the loan would become ‘sub-standard’ on 6^th May 2017 (i.e. 90 days after this date). Twelve months after this date i.e. from 6^th May 2018 onwards, the loan will be called a ‘Doubtful’ asset.

Note the following peculiarities in this:

1.       A loan does not become an NPA immediately after default. For 90 days, it continues as a ‘Standard’ asset, though conventionally one is inclined to equate 'standard’ assets as those where the customers are repaying on time. Thus, given that demonetization was announced on the evening of 8^th November 2016, even an asset due on 9^th November and remaining in default would not become an NPA on 31^st December 2016. And this even without taking recourse to the extra 60 days provided by the above circular.

2.       There is no hard & fast definition of a ‘Loss’ asset, it is based on a subjective assessment of the bank about the recoverability of the loan. In theory, a loan may continue to be classified as ‘Doubtful’ for several years after default, without ever being moved to ‘Loss’.

Why this classification matters is that the ‘provisioning’ banks are required to do – which, as we saw is an ‘expense’ and hits the bank’s profitability - depend on the category of the loan, progressively increasing as the loan moves down the quality lane from Sub-standard to Doubtful and Doubtful to Loss. RBI even requires banks to make provisioning on Standard assets.

Gross & Net NPAs

When banks declare their financial results, the 'Gross NPA’ and ‘Net NPA’ levels of the bank receive a lot of attention. The summation of assets under the category Sub-standard, Doubtful and Loss – are called the ‘Gross NPA’ of the bank. If you deduct the amount of provisioning done from the Gross NPA, the resultant figure is the ‘Net NPA’ of the bank. But we have seen above that provisioning is an arbitrary number – partly driven by a regulatory minimum, partly driven by the bank’s own discretion. This makes 'Net NPA’ also an arbitrary number. ‘Gross NPA’ however is a much more tangible number – it tells precisely the amount of loans overdue by 90 days or more. There is no subjectivity around it.

The NPA figures are often quoted in terms of percentages. When bank results are declared at the end of every quarter, analysts look at the ratios ‘Gross NPA %’ and ‘Net NPA %’ to determine the quality of bank's assets. Gross NPA % is calculated as ‘Gross NPA of the bank (as described earlier) divided by standard advances plus the gross NPAs’ of the bank i.e. effectively the sum of all loans outstanding as on the date of calculation. Net NPA% is calculated as the ‘Net NPA of the bank (as described earlier) divided by net advances’ i.e. sum of all loans outstanding less the provisioning for NPAs.

Note that only the absolute change in the Gross NPA comes close to showing the true movement of NPAs of the bank. And that too, with the lag of one quarter! That is, Gross NPA as of end-December minus the Gross NPA as of end-September will account for fresh defaults that have taken place in the July to September - and not the October to December - quarter! Net NPAs are distorted by provisioning, and both the ‘percentage ratios’ (Gross NPA% and Net NPA %) are distorted by the denominator. A bank can issue fresh imprudent loans and inflate the denominator, thus showing low NPA%. These fresh loans would become NPAs earliest only in the next quarter because of the 90-day rule.

It’s not over yet. There are write-offs too!

Even difference in Gross non performing assets doesn’t tell the full story of bank’s NPA movement. NPAs are further impacted by the assets “written off” during the period. And this figure may only be available from the Annual Report once a year. Written off assets are reversed completely from the asset book, reducing the Gross NPAs of the bank and the overall asset base itself.

Coming back to RBI circular mentioned earlier, all that the RBI said was that for loans with due dates between 1^st November 2016 to 31^st December 2016; banks have an extra 60 days – beyond the normal 90 - to recognize them as NPAs. They would become NPAs only if they remain unpaid for 150 days after the due date i.e. between 30^th March 2017 to 31^st May 2017 respectively, instead of 30^th Jan 2017 to 31^st March 2017. The asset classification and the amount of provisioning the banks have to do, would be guided accordingly.

As far as the borrowers are concerned, there was no change in their obligations to the bank; their due dates remained the same. There was no “EMI holiday” nor any “extra 60 days” to repay their credit.

Three myths about the "growth" debate

If one reads the country’s pink press or listens to the ‘experts’ appearing on television regularly, one might wonder why, with so many brains around to solve the country's problems, the problems are still there and not going away. The answer for this is not difficult to see. Given below are three common myths that surround the debate, making problem solving exercise an exercise in futility:

Myth # 1: GDP growth is utopia

No other economic statistic is probably as abused as “GDP growth”. Very few understand what (GDP) ‘growth’ is, and even fewer the limitations of this number. That is precisely why, probably, every politician worth his salt finds it a handy tool to misuse. GDP, or Gross Domestic Product, is the sum total of all output of final goods and services produced in the country in a given period. GDP growth then, is the increase in this output, adjusted for inflation. GDP growth shows how much more the country has produced compared to a previous period, usually the year. All this is fine. 

However, it is rarely discussed that:

What matters is not the absolute GDP growth but per capita growth, especially when comparing GDP figures between two different countries. For example, U.S. GDP grew by 2.78 % between 2011 and 2012, while India’s GDP grew at 4.99 %, faster than that of the U.S. However, India’s per capita GDP actually fell from $ 1,534 in 2011 to $ 1,489 in 2012 while U.S.’ per capita GDP grew from $ 48,113 to $ 49,965. (Source: World Bank). Indians were thus worse off than they were the previous year. All talk about India being “…one of the fastest growing economies in the world…” is thus meaningless, because India's per capita figures almost invariably turn out to be much worse.

Then there are other factors to be considered such as the composition of this GDP growth. In India, government buys food grains every year at higher and higher prices through an administrative fiat (MSP) with tax payer money which then rots in government godowns. This production counts as GDP, but it never reaches the consumer. With his remaining money, the tax payer ends up buying the remaining foodgrains in the open market at inflated prices, because so much of legitimate supply has gone out of market.

In a healthy economy, higher GDP figure should be supported by two other characteristics – increase in productivity and increase in job creation. India’s average GDP growth between 1999-00 to 2004-05 was 5.76 % and between 2004-05 and 2009-10 was 8.73 %. But the number of jobs created between 1999-00 to 2004-05 was 60.70 million whereas between 2004-05 to 2009-10 was just 2.72 million (Source: Planning Commission).

GDP growth is thus just a statistic that needs to be taken with a fistful of salt. GDP growth is an outcome of a healthy economy, but it does not necessarily constitute proof of one.

Myth # 2: The growth – inflation paradox

This probably is the biggest myth of them all – that the Central Banks are perpetually facing a Catch–22 situation: if rates are reduced (or liquidity increased, which has the effect of lowering rates) to propel growth, inflation flares up and if rates are raised (or liquidity tightened) to control inflation, growth suffers.

Let’s get this straight here – Bank lending and borrowing (i.e. deposit) rates move in tandem. If you want lending rates to come down, deposit rates need to be lowered too. And deposit rates cannot be delinked from inflation rate. Interest is the time value of money. The way an economy grows is like this: interest rates get high enough to encourage savings; this encourages people to save more. The banks (and others such as insurance & pension funds etc) become flush with money. They then compete among themselves to lend, which brings down lending rates. This in turn encourages more consumption and capital investment, promoting growth.

Lower interest rates are thus a result of increased availability of capital, which in turn is a result of increased savings, which in turn is a result of higher income and low inflation! That’s how low interest rate induces growth. All the economies which have shown high growth rates in the past, such as Singapore or China or even India have done so on the back of a high savings rate. Countries which tried to grow through excess leveraging, such as those in Europe or the U.S. are facing problems today.

What happens if inflation rate is higher than the rates of return savers get (the so-called negative real interest rate)? If inflation is high, disposable incomes fall; inducing people to cut down on discretionary consumption. There is also a flight of capital to hard assets and speculative investments, causing asset price bubbles.

Myth # 3: Central Banks can cure all economic ills

The media pays too much attention to Central Bank actions. The Central Bank can only do this much, and nothing more. It has the mandate to maintain the value of the currency, to oversee (but not to run) the banks and to run the credit & payment system in the country. The fiscal policy, the trade policy, the industrial policy, the law and order, the availability of manpower and requisite skill sets, the legal framework, the ease of doing business – there are several factors that impact how the economy performs. Most of these are under government influence. Most of the times, governments make things worse, in the guise of ‘regulating’ them. You just can’t expect the Central Bank to have a magic wand which will make all sins of the government disappear and power the economy full throttle.

In a 2012 World Bank ranking of 185 countries on “Ease of Doing Business", India ranked 132^nd. The rankings rate countries on parameters such as starting a business, dealing with construction permits and enforcing contracts. Here is the latest example - a bill introduced in Indian Parliament to “regulate” street vendors will soon make it impossible for anyone to even sell peanuts on the streets. And we expect Central Bank to promote growth!

When you bust these myths, most of what appears in the pink press or the business channels on how to promote growth will cease to make any sense.