The Reserve Bank of India headquarters in Mumbai. (GettyImages)

RBI’s Financial Stability Report Sounds Alarm Bells Over NPAs

Warning: a severe credit shock is likely to impact the capital adequacy and profitability of a significant number of banks.

The December 2017 issue of the financial stability report (FSR) of the Reserve Bank of India (RBI) has sent alarm signals around the financial sector. Gross non-performing assets (NPA) in the banking sector were a focus in the report. The figure as projected by the report was 9.6 per cent in March 2017 and 10.8 per cent in 2018. In absolute numbers, NPAs comprise about Rs 7.15 lakh crore of gross advances of Rs 72.5 lakh crore.

NPAs essentially imply loan advances on which interest and principal payments are overdue. So it appears that there is a systemic risk in the making. At least that is what the RBI appears to have conveyed. According to FSR, “a severe credit shock is likely to impact the capital adequacy and profitability of a significant number of banks". This alarm was reinforced with the FSR forecast that the NPAs would rise to 10.8 per cent by March 2018. Assuming that outstanding credit would end the year at about Rs 82 lakh crore, the projections translate into to a gross NPA of about Rs 9 lakh crore or close to about 6 per cent of the nominal gross domestic product. The Union budget of 2017-18 had estimated the gross domestic product (GDP) at Rs 168 lakh crore.

Obviously, in this given scenario, the government had to act. With the FSR projection already foreseen by the Finance Ministry, it announced a Rs 2.11 lakh crore recapitalisation scheme, of which Rs 1.35 lakh crore is expected to be in the form recapitalisation bonds. These are bonds that would be placed with the banks, though the coupon or interest rates on the bonds are yet to be revealed. However, coupon payments depend on the tenure of the bonds. But recapitalistion bonds essentially mean that the depositor funds are used for recapitalisation, since it is these funds that would be used to subscribe for the bonds. The remaining Rs 76,000 crore would be in the form of direct equity infusions into the banking system and the remaining through market borrowing, or capital bonds or subordinated bonds as they are commonly referred to in the financial markets.

But there are some fundamental questions that remain unanswered. The first one is the NPA estimates by the RBI and the banking sector. There has always been a nagging suspicion that the banks and the RBI are overestimating the NPA issue. This is because of the peculiar nature of the accounting. The RBI has imported the accounting norms of the Cooke Committee of the Bank for International Settlements with little modification. The only modifications that were applied were for the statutory obligations under the SLR (statutory liquidity ratio that mandates investment in sovereign securities as prescribed by the RBI) and the cash reserve ratio (the amount of cash balances that the banks are expected to maintain with the RBI against their deposits). The Cooke Committee norms prescribe classification of NPAs if debt service repayments are overdue beyond 90 days.

But NPA classifications are particularly biased against the farm sector since it overlooks the crop cycle of Indian agriculture. For instance, paddy and wheat typically take anywhere between 120 and 160 days from planting to harvest. Any credit overdue beyond the recommended 90-day limit are automatically converted to substandard assets. That means that in qualifying a credit as standard or substandard or loss assets, even as the crop is waiting to be harvested, a case of one size fits all. Consequently, this application means that farmers end up paying penalties on borrowings. Any repayment of a loan can only be done if there is an income. In the case of the farm sector, income comes only after the crop is harvested and the income is realised from sale of the proceeds from the markets or from government agencies that procure the crops.

The second anomaly is the way policy rates have been behaving. Ideally in an environment where credit quality has deteriorated interest rates cannot be allowed to fall. Policy interest rates by the RBI have been allowed to drop to 6 per cent from 7.75 per cent in 2015. The policy interest rate, referred to as repurchase (repo) is the interest at which the RBI provides overnight cash support to banks against collateral of sovereign securities. After all if credit is to be treated as commodity, in a loss environment, the pricing has to logically increase. However, in the Indian context, despite the projected rise in the NPA, interest are actually allowed to drop. Take the case of the peak savings deposit rate. Peak savings deposit rate were close to 10 per cent in 2015 for three to five-year tenures. The rates now are less than 6 per cent, leading shift to savings to non-bank assets.

But what is also true is that banks are cash surfeit. The leading factor of the cash in the banking system stems from slowdown in credit off-take from the banking system. A slowdown in credit off-take in the banking system also partly contributes to the reduced investment in the economy. This is a fact that has been admitted by the FSR, but largely ignored by mainstream financial and general media that remain interest rate reduction obsessed. The FSR states, “investment demand as measured by the gross fixed capital formation remained depressed with its share in the GDP declining from 34.3 per cent in 2011-12 to 29.5 per cent”. Gross fixed capital formation is the outlay for additions to fixed assets (plant machinery, equipment, building and inventories of partially completed goods). Obviously, if investment has not been happening, it means that employment generation in the industrial sector is also slow.

However, the cash surplus in the banking sector is not just due to low credit off-take. Foreign portfolio flows have played a role. Foreign portfolio inflows have resulted in an increase in cash in the market, as is evident from the exchange rate appreciation against the dollar. The rupee has appreciated by 7 per cent over the last one year. But excessive reliance on foreign flows is not necessarily positive.

But the fact is that foreign inflows into the country have actually accelerated post demonetisation and there is less flight capital. Yet for the this capital inflows to translate into investment and long term employment generation still requires some more work. Hopefully budget 2018-19 could be expected to address this particular issue.