Pro-cyclical Management of Banks’ Non-Performing Loans by the Indian Public Sector Banks

Following the implementation of the Basel Accord across several countries, a large literature including Borio, Furpine and Lowe (2001), Borio and Lowe (2002), White (2006) has emerged on the subject of procyclicality of bank indicators.

Economists‟ concern derives from the key lesson learned from the various crises including the recent global crisis originating from an advanced economy like the US, i.e., the procyclicality of financial indicators could contribute to the amplification of the business cycle and thereby, pose problems for macroeconomic policies for stabilization purposes.

From policy perspective, many studies have suggested that regulators could adopt counter-cyclical prudential measures for maintaining financial stability and ensuring sustained economic progress.

According to White (2006), such a policy framework could entail a new macroeconomic stabilization framework and symmetric policy response to the expansionary and contractionary phases of the financial cycle.

Taking inspirations from the literature, this study focuses on the Indian context. There are several motivations for the study. The Indian context could provide crucial insights about the experience of a leading emerging market economy.

India adopted financial sector reform in the early 1990s, with a focus on the banking sector that constitutes the predominant component of the financial system.

As part of the banking sector reform, India adopted various prudential norms in line with the Basel Accord, apart from introducing measures aimed at strengthening price discovery process in the financial markets and competition in the banking sector based on the recommendations of the two high level committees on banking sector.

Reflecting the success of financial sector reform, the Indian economy witnessed rapid progress during the post reform period, notwithstanding the episodes of contraction in the economy during the late 1990s and the early part of the current decade due to various adverse external and domestic developments such as the Asian crisis, the world recession and the poor monsoon.

The average growth rate of real Gross Domestic Product (GDP) increased to 6.4 per cent and 8.8 per cent during the 1990s and 2003-08, respectively, from the growth rates of 5.8 per cent during the 1980s and 3.5 to 4.0 per cent, the latter often referred to „hindu growth’ rate, during the 1950s through the 1970s.

In tandem with the economic progress, the banking sector also showed significant improvement in terms of various prudential indicators relating to capital, asset quality, management, efficiency and liquidity. In this milieu, several pertinent questions arise.

How did Indian banks manage to show improved performance? How did Indian banks overcome the business cycle? Whether bank indicators in India are procyclical in nature? Whether there were several other variables which contributed to the banks‟ performance over the years.

This study is focused on nonperforming loans, which reflect on the credit risk management by the banks* .There is a considered view that loan defaults could be managed by appropriate risk pricing of loans encompassing the terms of credit variables such as interest rate, maturity, collateral, and credit culture.

For the empirical evidence, the study uses pooled regression analysis based on the balance sheet data of 27 public sector banks over the period 1996 to 2008. These public sector banks account for the bulk of the banking system in terms of aggregate deposits, credit, and investments.

Deriving from the literature on the subject, we demonstrate that apart from the business cycle, the terms of credit variables played an important role with statistically significant effects on the banks' non-performing loans in the presence of bank size induced risk preferences and macroeconomic shocks.

The changes in the cost of credit in terms of higher interest rate induce rise in the NPAs. On the other hand, factors like maturity of credit, better credit culture and favorable macroeconomic and business conditions lead to lowering of the NPAs.

Business cycle may have differential implications adducing to differential response of borrowers and lenders. These findings have implications for regulation and policy. The remainder of the study is structured in three sections comprising the review of literature, empirical findings, policy implications and conclusion in that order.

THE LITERATURE

From a cross-country perspective, studies on the problem of loan defaults or nonperforming loans (NPLs) bring to the fore several useful perspectives. Sergio (1996) in a study of non-performing loans in Italy found that an increase in the riskiness of loan assets is rooted in a bank‟s lending policy adducing to relatively unselective and inadequate assessment of sectoral prospects.

Business cycle could be a primary reason for banks‟ nonperforming loans. But the increase in bad debts as a consequence of recession alone was not empirically demonstrated. In a study of loan losses of US banks, McGoven (1993) argued that „character‟ has historically been a paramount factor of credit and a major determinant in the decision to lend money.

Banks have suffered loan losses through relaxed lending standards, unguaranteed credits, the influence of the 1980s culture, and the borrowers‟ perceptions.

Thus, the study suggested that bankers should make a fairly accurate personality-morale profile assessment of prospective and current borrowers and guarantors. In addition, banks could minimise risks by securing the borrower‟s guarantee, using Government guaranteed loan programs, and requiring conservative loan-to-value ratios.

Bloem and Gorter (2001) suggested that a more or less predictable level of non-performing loans, though it may vary slightly from year to year, is caused by an inevitable number of „wrong economic decisions‟ by individuals and plain bad luck (inclement weather, unexpected price changes for certain products, etc.).

Under such circumstances, the holders of loans can make an allowance for a normal share of non-performance in the form of bad loan provisions, or they may spread the risk by taking out insurance.

Enterprises may well be able to pass a large portion of these costs to customers in the form of higher prices. For instance, the interest margin applied by financial institutions will include a premium for the risk of non-performance on granted loans.

Bercoff, Giovanniz and Grimardx (2002) using accelerated failure time (AFT) model in their study of Argentina‟s banking sector‟s weakness measured by the ratio of non-performing loans to total loans found that both bank specific indicators such as asset growth, the ratio of net worth to net assets, the ratio of operating cost to assets, exposure to peso loans, and institutional characteristics relating to private bank and foreign bank and macroeconomic variables including credit growth, foreign interest rate, reserve adequacy and monetary expansion, besides the tequila effect were reasons behind the banking fragility.

Their empirical results suggested that the bank size measured by assets had a positive effect but asset growth had a negative effect on NPLs. The variables such as operating cost, exposure to peso loans, credit growth, and foreign interest rate had negative effect on NPLs.

The macroeconomic variables such as money multiplier, and reserve adequacy, institutional characteristics and tequila effect had positive influence on NPLs. Fuentes and Maquieira (1998) undertook an in-depth analysis of loan losses due to the composition of lending by type of contract, volume of lending, cost of credit and default rates in the Chilean credit market.

Their empirical analysis examined different variables which may affect loan repayment such as the limitations on the access to credit, macroeconomic stability, collection technology, bankruptcy code, information sharing, the judicial system, prescreening techniques, and major changes in the financial market regulation.

They concluded that a satisfactory performance of the Chilean credit market, in terms of loan repayments hinges on a good information sharing system, an advanced collection technology, macroeconomic performance and major changes in the financial market regulation.

In another study of Chile, Fuentes and Maquieira (2003) analysed the effect of legal reforms and institutional changes on credit market development and the low level of unpaid debt in the Chilean banking sector.

Using time series data on yearly basis (1960-1997), they concluded that both information sharing and deep financial market liberalisation were positively related to the credit market development. They also reported less dependence of unpaid loans with respect to the business cycle compared to interest rate of the Chilean economy.

Altman, Resti and Sironi (2001) analysed corporate bond recovery rate adducing to bond default rate, macroeconomic variables such as GDP and its growth rate, the amount of bonds outstanding, amount of default, return on default bonds, and stock return.

It was suggested that default rate, amount of bonds, default bonds, and economic recession had negative effect, while the GDP growth rate, and stock return had positive effect on corporate recovery rate.

Lis, et.al.,(2000) used a simultaneous equation model in which they explained bank loan losses in Spain using a host of indicators, which included GDP growth rate, debt-equity ratios of firms, regulation regime, loan growth, bank branch growth rates, bank size (assets over total size), collateral loans, net interest margin, capital-asset ratio (CAR) and market power of default companies.

They found that GDP growth (contemporaneous, as well as one period lag term), bank size, and CAR, had negative effect while loan growth, collateral, net-interest margin, debt-equity, market power, regulation regime and lagged dependent variable had positive effect on problem loans.

The effect of branch growth could vary with different lags. Kent and D‟Arcy (2000) while examining the relationship between cyclical lending behaviour of banks in Australia argued that the potential for banks to experience substantial losses on their loan portfolios increases towards the peak of the expansionary phase of the cycle.

However, towards the top of the cycle, banks appear to be relatively healthy; non-performing loans are low and profits are high, reflecting the fact that even the riskiest of borrowers tend to benefit from buoyant economic conditions.

While the risk inherent in banks‟ lending portfolios peaks at the top of the cycle, this risk tends to be realized during the contractionary phase of the business cycle. At this time, banks‟ non-performing loans increase, profits decline and substantial losses to capital may become apparent.

Eventually, the economy reaches a trough and turns towards a new expansionary phase, as a result the risk of future losses reaches a low point, even though banks may still appear relatively unhealthy at this stage in the cycle.

Jimenez and Saurina (2003) used logit model for analysing the determinants of the probability of default (PD) of bank loans in terms of variables such as collateral, type of lender and bank-borrower relationship while controlling for the other explanatory variables such as size of loan, size of borrower, maturity structure of loans and currency composition of loans.

Their empirical results suggested that collateralised loans had a higher PD, loans granted by savings banks were riskier and a close bank-borrower relationship had a positive effect on the willingness to take more risk.

At the same time, size of bank loan had a negative effect on default while maturity term of loans, i.e., short-term loans of less than 1-year maturity had a significant positive effect on default. In the Indian context, there is a considered view that banks‟ lending policy could have crucial influence on non-performing loans (Reddy, 2004).

He critically examined various issues pertaining to terms of credit of Indian banks and argued that „the element of power has no bearing on the illegal activity. A default is not entirely an irrational decision.

Rather a defaulter takes into account probabilistic assessment of various costs and benefits of his decision‟. Reddy (2004) raised various critical issues pertaining to credit delivery mechanism of the Indian banking sector.

The study focused on the terms of credit such as interest rate charged to various productive activities and borrowers, the approach to risk management, and portfolio management in general.

There are three pillars on which India‟s credit system was based in the past; fixing of prices of credit or interest rate as well as quantum of credit linked with purpose; insisting on collateral; and prescribing the end-use of credit.

Interest rate prescription and fixing quantum has, however, been significantly reduced in the recent period. The study also highlighted the issues in security-based or collateralised lending, which need careful examination in the context of growing services sector.

Given the fungibility of resources, multiple sources of flow of resources, as well as application of funds, the relevance and feasibility of end-use restrictions on credit need a critical review.

The link between formal and informal sectors shows that significant divergence in lending terms between the two sectors still persists, despite the fact that the interest rate in informal markets is far higher than that of the formal sectors- the banking sector.

The convergence between formal and informal sectors could be achieved by pushing the supply of credit in the formal sector following a supply leading approach to reduce the price or interest rate. Furthermore, in the context of NPAs on account of priority sector lending, it was pointed out that the statistics may or may not confirm this.

There may be only a marginal difference in the NPAs of banks‟ lending to priority sector and the banks lending to private corporate sector.

Against this background, the study suggested that given the deficiencies in these areas, it is imperative that banks need to be guided by fairness based on economic and financial decisions rather than system of conventions, if reform has to serve the meaningful purpose.

Experience shows that policies of liberalisation, deregulation and enabling environment of comfortable liquidity at a reasonable price do not automatically translate themselves into enhanced credit flow.

Although public sector banks have recorded improvements in profitability, efficiency (in terms of intermediation costs) and asset quality in the 1990s, they continue to have higher interest rate spreads but at the same time earn lower rates of return, reflecting higher operating costs (Mohan, 2004).

Consequently, asset quality is weaker so that loan loss provisions continue to be higher. This suggests that, whereas, there is greater scope for enhancing the asset quality of banks, in general, public sector banks, in particular, need to reduce the operating costs further.

The tenure of funds provided by banks either as loans or investments depends critically on the overall asset-liability position. An inherent difficulty in this regard is that since deposit liabilities of banks often tend to be of relatively shorter maturity, long-term lending could induce the problem of asset-liability mismatches.

The maturity profile of commercial bank deposits shows that less than one fifth is of a tenor of more than three years. On the asset side, nearly 40 per cent has already been invested in assets of over three year maturity.

Banks also have some capacity to invest in longer term assets, but this capacity will remain highly limited until the fiscal deficit remains as high as it is and the Government demand for investment in long dated bonds remains high.

Some enhancement of their capacity to invest in infrastructure, industry and agriculture in longer gestation projects can be achieved by allowing a limited recourse to longer term bond issues. I

n an another study, Mohan (2003) observed that lending rates of banks have not come down as much as deposit rates and interest rates on Government bonds.

While banks have reduced their prime lending rates (PLRs) to some extent and are also extending sub-PLR loans, effective lending rates continue to remain high. This development has adverse systemic implications, especially in a country like India where interest cost as a proportion of sales of corporates are much higher as compared to many emerging economies.

The problem of NPAs is related to several internal and external factors confronting the borrowers (Muniappan, 2002).

The internal factors are diversion of funds for expansion, diversification and modernisation, taking up new projects, helping/promoting associate concerns, time/cost overruns during the project implementation stage, business (product, marketing, etc.) failure, inefficient management, strained labour relations, inappropriate technology/technical problems, product obsolescence, etc., while external factors are recession, non-payment in other countries, inputs/power shortage, price escalation, accidents and natural calamities.

In the Indian context, Rajaraman and Vasishtha (2002) in an empirical study provided an evidence of significant bivariate relationship between an operating inefficiency indicator and the problem loans of public sector banks.

In a similar manner, largely from lenders‟ perspective, Das and Ghosh (2003) empirically examined non-performing loans of India‟s public sector banks in terms of various indicators such as asset size, credit growth and macroeconomic condition, and operating efficiency indicators.

The Indian viewpoint alluding to the concepts of „credit culture‟ owing to Reddy (2004) and „risk pricing‟ owing to Mohan (2003a) confirm with several studies mentioned in the above that apart from the business cycle, banks‟ lending policy could play an important role in the management of loan defaults.

EMPIRICAL ANALYSIS

A comparative picture of the trends Gross NPA ratio and various other bank indicators including the terms of credit variables relating to maturity (share of term loans in total advances), interest cost of deposits, operating expenses to asset ratio, loan collateral (the share of unsecured loans), credit-deposit ratio deriving from the balance sheets of 26 public sector banks in India since 1995-96 is presented in Table 1 and Annex 1.

The average credit-deposit ratio of banks increased from slightly less than 50 per cent in the second half of the 1990s to 71 per cent by March 2009, reflecting the impact of financial sector reform and the changes in monetary policy such as the reduction of statutory liquidity requirement and cash reserve ratio and softening of interest rates.

However, the growth of credit did not show the deterioration in asset quality as the management of NPAs showed significant improvement. The gross NPAs as percentage to advances declined from about 18 per cent in 1995-96 to 1.7 per cent in 2008-09.

The declining trend in the Gross NPA ratio was accompanied by the rising trend in the loan maturity, declining loan interest rate, the improvement in managerial efficiency through the reduction in banks‟ operating cost, strengthening of capital to risk weighted assets and the improvement in the banks profitability (return on assets).

Panel Regression Results

The essence of a cross section analysis is to provide meaningful analysis of interlinkages among economic and financial variables after duly recognising the heterogeneous nature of economic agents and their behavior.

If economic agents were similar, a time series analysis would serve a meaningful purpose. The panel regression methodology recognises individual characteristics as well as regularity and/or continuity in the cross-section units in order to establish a meaningful relationship between different economic and financial variables.

In this context, a pertinent question arises whether public sector banks are homogeneous or heterogeneous in nature. From an institutional perspective, it may be argued that public sector banks are similar entities.

However, it was evident that the economic behaviour of each bank as reflected in various stylized facts about the loan portfolio, the cost structure and the performance could not be similar. This was evident from cross-section maximum and minimum values and the variability of various indicators (Annex 1). Thus, a cross section analysis assumes importance.

Location: Indonesia