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Rising NPAs: Where has all the money gone?

Ashok K Lahiri

In America, the bankruptcy of WorldCom, one of the world's largest energy and telecom companies, is bringing poor accounting methods and shoddy business practices to the front page.

But in India, how much lost money will it take for the problem of non-performing assets of the public sector banks to receive attention and urgent action? Is Rs 536 billion not enough?

These were, according to provisional Reserve Bank of India estimates, the gross NPAs of India's public sector banks in 2001-02. As a proportion of that year's gross domestic product, it was almost 2.6 per cent. Where has all the money gone?

Investors lose money even in developed countries because of unethical or fraudulent practices. The scandals at Enron and WorldCom are only the most recent of a long string of scams.

How much of the Rs 536 billion is caused by such practices, and not pure commercial risk?

Finance Minister Jaswant Singh, on July 23, described the NPAs of public sector banks as "loot and not debt." This is what ordinary people have been suspecting about a large portion of NPAs.

Diversion of funds to purposes other than what the money is borrowed for, and embezzlement by over-invoicing in the project implementation stage, are well-known problems in the Indian credit market.

The NPA problem is not unique to India. There was the bankruptcy problem of the savings and loan associations in the United States more than a decade ago.

Even developed countries have NPA problems, but they hardly ever exceed 2-4 per cent of advances. In Malaysia, Singapore and South Korea, after the East Asian crisis, NPAs' proportion of total advances was 9.5 per cent in November 2000, 9.7 per cent at end of 1999, and 7.1 per cent in September 2000.

But the NPA problem of public sector banks in India is somewhat larger. In 2000-01, the NPAs of Indian public sector banks as a proportion of their total advances were 12.4 per cent.

Part of the reason for NPAs is commercial risk. A loan - unlike equity - is a fixed payment contract, irrespective of whether there is profit or not.

Yet businesses fail and the contractual payments are not honoured. If the loan is secured through collateral, the bank can seize and sell the collateral, but in many countries that involves legalities and delays.

Many loans carry a risk premium as a reward for the banks taking the risk of lending. Some loans are not fully collateralised, and carry higher risk premiums.

Furthermore, banks do make errors in judgement, and some loans do turn out to be unduly risky or fraudulent. But, Rs 536 billion is too much money to be explained by commercial risk or errors in judgement.

While a small part of Rs 536 billion may be because of commercial risks, a large part is malfeasance.

Industrialists who failed to repay their loans to the public sector banks continued to live life on the fast track, leveraging the leniency of the loan collectors to finance their own lavish lifestyles. Sadly enough, there is no social sanction against such behaviour.

The corruption problem does not lie only with the business sector, and corruption in banking is difficult to prove. Allegations abound, but cases of successful prosecution and conviction are rare.

Furthermore, investigations into alleged corruption - even when credit decisions were taken with no malafide intentions and the occurrence of NPAs was because of the inherent commercial risks - have created fear psychosis among bank staff and slowed down the decision-making process.

According to some knowledgeable people, while there may have been corruption at some levels in a few cases, the problem was more of ineptitude and lack of due diligence.

Lack of due diligence, systemic failure and corruption are the three root causes of the NPAs. There was a lack of due diligence in many cases on the part of the staff, and loan proposals were approved by the boards as a matter of routine.

The public sector banks had very little or no floating stocks and the stock market provided no feedback about the health of the bank. The only feedback these banks got was from the RBI in the form of annual inspection reports.

Lack of due diligence was also reflected in a failure to prepare all the necessary loan security documents, to recall the loan in time, to convert the loan into equity, to follow up on the legal proceedings, and to enforce contracts.

Particularly in the period prior to 1992-93, when the RBI introduced the prudential norms, banks took little action against defaulters and continued to account for interest as income on an accrual basis even when the underlying advances were not performing.

A major reason for the NPA problem is the systemic failure. Recovery, once a loan turns sticky, is notoriously difficult in most countries, and ridiculously difficult in some.

In India, until recently, security could be enforced only through court intervention. Many loans were secured by personal guarantees, but the bank could proceed against the guarantors only after enforcing other security interests.

A reference to Board for Industrial and Financial Reconstruction could stall the entire process of loan recovery. Trying to revive a sick unit that has become inherently non-viable often leads to an even higher NPA over time.

The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Ordinance promulgated on June 24 has removed many of these limitations.

Let us hope that the problem of systemic failure can be somewhat tackled.

No one likes to admit failures, and banks are no exception. Classifying a loan as an NPA is an admission that the bank failed in its judgement.

Giving the borrower another loan just as he is going to exceed the limit of 180 days in not paying his dues to the bank, with the understanding that he will meet his obligations to the bank from the proceeds of the loan, is called the process of ever-greening.

Evergreening is only a method of throwing good money after bad money, and a way of postponing the problem. The problem comes back in the form of a bigger NPA.

Yet, the banks indulge in evergreening because income on NPAs can be booked only when it is actually received in cash. A dip in profits is the price for mustering up the courage to classify a loan as an NPA.

There are further costs to classifying a loan as an NPA, for such a classification affects the balance sheet.

The banks have to make full provision for loss assets and for the unsecured portion of doubtful assets; 20-50 per cent provision - depending on the period for which the account is doubtful - for the secured portion of doubtful assets; and a general 10 per cent provision for sub-standard assets.

Banks are not supposed to be popular institutions. Rather than pleasing the people, they are supposed to be suspicious and mean - suspicious when granting a loan, and mean while collecting dues.

Perhaps a recognition of this unpopular role, and the necessary regulatory and procedural changes that stem from such a recognition, would go a long way towards recovering some of the Rs 563 billion - or at least towards ensuring that such a disproportionately large NPA problem does not occur again.

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