Indian Banking, Non-Performing Assets & Corporate Governance: Why NPA So High?
| Author | Padhi, Satya Prasad |
Introduction
A central policy focus would be on the need for sustaining a greater bank credit flows to sustain higher growth phases. In the existing literature the need for human capital-related expertise to enhance operational efficiency of Indian domestic banks to control quality of loans (and therefore lower NPA) has received adequate attention. This can sustain the correlation between higher credit flows and growth. A mere emphasis on higher interest costs to control the quality of credit flow, for instance, can adversely impact economic activity and result in higher nonperforming assets (NPA) of Indian Banks (Chavan & Gambacorta, 2016).
However, what is neglected is that the higher growth phases normally would also create stressed loans (RBI, 2010), especially the corporate ones. The challenges facing the nature of human capital-base and expertise to effectively restructure the loans that involve corporate governance issues have not received enough attention in the related literature. It would be reasoned how a lack of expertise, and such human capital base, to face the challenge of proper restructuring of stressed loans can cause the prospects of banks' freeriding that can translate into higher NPA.
To elaborate on this theme, we would highlight how existing Indian literature remains silent on the human capital expertise needed to address stressed loans arising in high growth phases. The emphasis would be on some factors that create such issues in high growth phases. We would address the need and importance of restructuring of loans to sustain higher credit flows with lower NPA. We would, then, examine the human capital expertise-centric challenges that face Indian banking and how neglect of this issue can raise the NPA prospects.
Human Capital Concerns
The average figures of NPA in Indian banking are considered high compared with that of the figures for the banks associated with the developed status of the countries. Though definitions of NPA are not comparable across countries, India's NPA as a percentage of total gross loans of 7.9 percent in the recent periods (taking 2000-2020) could be considered high as compared to that of the figures that lie generally below 2 percent for the fast growing countries like China and Korea and most of the developed countries (data.wouldbank.org/indicator/FB.AST.NPER.EZ; for recent trends, see RBI, 2021). Banking in India, especially in the market reform era, faces capital requirement targets in a more competitive environment. Non-performing loans and the resultant loss of value of the assets would mean the banks may lose out in extending their businesses or acquiring capital unfavorable terms. Both would indicate a serious loss of competitive advantages.
A proper accounting of NPA and the norms for capital adequacy ratio could represent a right policy focus. However, Huljak et al (2020) modeled how exogenous changes in NPA, say due to policy changes, are likely to impair economic activity through reduced credit flows. Such high NPA ratios in banks' balance sheets can adversely affect the soundness of the banking system through reduced profits, higher provisions, higher expenses associated with their monitoring and management. All this leads to an increase in funding costs, and higher risk weights-led higher capital needs. To maintain or boost capital adequacy, banks may thus deleverage, leading to a contraction in credit supply. Finally, the management of large NPA stocks can divert important managerial resources away from the core and more profitable activities. In these instances, reduced credit flows and resultant economic activities lead to a decline in the repayment capacity of borrowers and a further increase in NPA.
Therefore, if the policy focus would be on sustaining higher credit flows (and economic activity), a greater operational efficiency that sustains higher credit flows allowing for their quality assumes significance. Indian studies underline the role of advanced human capital that is information-intensive and the staffing pattern should reflect this aspect. Anand (2000), D'Souza (2002) and Kumar (2008), in particular, emphasize how staffing pattern tilted in favor of officers-dominated employees not only is associated with lower establishment costs, a more considerable value attached to customer relations and management of assets (and the risks), but also permits effective multi-tasking as the banking practices go beyond mere advance of loans to expand portfolio choices (to manage exposure to mere advances). Following this, there has also been related literature (Kamath, 2000; Mandal & Ghose, 2012) that emphasizes intellectual capital, a combination of human capital and related advanced technology-based physical capital that adds force to this aspect of banking that can add to efficiency and profitability. Banks face choices when they decide on advances to specific borrowers; the lack of proper employment would imply less control over NPA.
This emphasis on human capital would focus on bank-specific factors, such as the 'bad management' hypothesis, the lack of adequate leverage and capital-related issues, the scope of 'moral hazard' and risks, and the possible lack of proper size and diversification bases, etc. (for a review, see, Chavan & Gambacorta, 2016; for Indian specific studies, see, Rajaraman and Vasishtha (2001); Das and Ghosh (2007); Swamy (2012); studies analyzing the effect of the repayment ability of borrowers on the loan quality of banks with a special focus on public banks see, Ranjan & Dhal, 2003, and Misra & Dhal, 2010).
However, allowing for operational efficiency and such institutional parameters, literature also suggests the independent role of macroeconomic parameters such as incidences of higher growth phases that highlight procyclicality of credit growth-led higher NPA. Minsky (1982) could be the first to provide a post Keynesian theoretical foundation of how banks' lending in high growth phases undermine that the loans are not hedged against long run payments. Recent literature provided alternative theoretical foundations, such as herd behavior, or various cognitive biases such as 'disaster myopia' or short-sightedness in underestimating the likelihood of high loss low-probability events, or how as growth picks up, banks tend to expand their credit limits because the valuation of underlying collateral goes up during the period, or banks may finance sub-prime borrowers who were not deemed credit-worthy and hence did not have an access to the credit market earlier (for a review, see, Jimenez & Saurina, 2006; Chavan & Gambacorta, 2016; RBI, 2016).
In this focus, Indian studies mostly concern the empirical validity of the procyclicality hypothesis (Chavan & Gambacorta, 2016; RBI, 2016). However, what is relatively neglected in this literature is how procyclicality is a problem and calls for banks' specific, new sets of expertise.
One, even when banks have the operational efficiency in the sanction of loans and have adequate knowledge of (or proper attention to) market conditions and borrowers, higher growth phases also typify demand and supply shocks and imply continuous changes in the market conditions facing borrowers and can also change the profile of the borrowers. Such shocks would have its effects on the profitability of the borrowers. Banks then have to keep a watch on how changing opportunities in the market impact the value of the assets in an ongoing manner (in the post-lending situations). Wilson (2000) cautions banking financial accounting has to adjust to both the risks and liquidity issues emanating from the constant coming up of new opportunities. In the face of continuous changes, he explains, accounting practices linked only to current business with a given set of parameters would be like driving a car guided only by the rear-view mirror. In the present discussion, it would be argued, this understanding provides the key to what drives up the NPA.
Second and typical of corporates, there is extensive literature on how post-high growth financial and corporate distress could be traced to violation of minority interests and (the resultant) tendency to take higher risks by the managers (Adams et al, 2000). What would be important, as Marris (1968) (also see, Hay & Morris, 1991) noted, higher growth phases would witness higher expansion plans of firms with long run survivability that can bring in the tradeoff between growth plans of firms and profitability. Beyond the need of maintaining market shares, expansion plans give more power to managers of corporates. With some separation of owners from the objectives of the firms, managers can pursue a higher growth objective (and imprudent, high-risk financial policies) that can come in conflict with the objective of profits maximization. That is, higher growth phases and more power of managers, can combine to undermine minority rights (whose interest otherwise would be more aligned to banks' interests). In general, firms not adapting to the shocks in high growth phases, or adjusting via higher risks raise corporate...
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