Just when banks were beginning to see light at the end of the NPA tunnel, the pandemic brought the spectre back again. With sizeable loan portfolios under moratorium (over 60 per cent of banks and 49 per cent of NBFCs), forecasts about the NPA levels and the capital to be raised are grim. The RBI is more sanguine. Its latest FSR projects the NPAs to rise to 12.5 per cent of advances by next March, but does not seem unduly worried about the safety and resilience of the system. Its optimism perhaps comes from the fact that banks are well capitalised, have sufficient high-quality liquid assets (HQLAs) and inter-bank linkages are now lower.

Ordinarily, financial systems are considered stable if banks can pay their debts and pass their regulatory capital tests. On this count, we have not witnessed bank failures in the past even when NPA ratios were high — 10.7 per cent in 2017 and 12.3 per cent in 2018.To be sure, a few banks got into trouble (PNB, PMC Bank, YES Bank) but these were more due to frauds or scams, rather than a failure to meet repayment obligations. And banks have passed the CRAR norms. This is not to say that bad loans and low capital are not a problem, but only that the banking system seems to have found ways to live with them without rocking the boat. It is interesting to understand how they managed, despite large NPAs and poor profitability.

Deposit factor

The RBI provides a few reasons in its report, but there are also some structural factors at play. First, the banking business is not significantly dependent on cash flows from operations, unlike non-financial entities, because operating margins are thin (even negative, in many cases). Cash flows from financing, ie deposits, are more crucial. Thus, if the loss of interest income on the NPA portfolio of around ₹9 trillion (as on March 2020) leaves a cash-flow hole of around ₹95,000 crore (at a weighted average lending rate of 10.5 per cent), net deposit flows, on an average, have ranged between ₹9-10 trillion. As long as deposits flow, banks may not feel the pinch, although loan loss provisioning would definitely cut into their profits.

Second, the reason why the flight risk of deposits is low has probably to do with their nature — a large part (40 per cent) of the deposits is transactional money (CASA deposits) and not savings, which are sensitive to interest rate and risk. These flows generally move in line with the level of transaction activity in the economy and are therefore more stable. Even time-deposits are split between retail (55 per cent) and institutional (45 per cent), further toning down the risk of large scale flight.

Third, the public sector character of banking (PSBs form 75 per cent of the system) lends an implicit, if unreal, sense of safety. It is a grand bargain, in the words of a former RBI governor — in return for capital and guarantee of their liabilities, PSBs finance government debt and lend to priority sectors. In fact, their holding of government securities is well in excess of the SLR requirement, which is a measure of their risk aversion, although other regulatory norms (LCR, CRAR) have also pushed them to hold large levels. The RBI has been critical of their excessive risk-aversion as being unhelpful in the cause of economic recovery, but on the flip side, it seems to have helped the cause of financial stability.

Raising funds

The other concern with increased NPAs is capital raising. The RBI’s projections here are less ominous — Tier-I capital of banks is likely to drop by a percentage point to 10.7 per cent by March under baseline conditions. The problem is mainly confined to PSBs, as they have the largest share of NPAs. Capital raising for PSBs has always been a challenge even in the pre-Covid era; for one, the privatisation issue will be tough to get past politicians, trade unions and perhaps even the government, because PSBs have been the proverbial golden goose.

There is also the larger problem of fiscal deficit which restricts the government’s capacity to fund. In the past, it managed this in part through accounting subterfuges such as recapitalisation bonds, wherein more than ₹2.5 trillion was injected since 2017.

Finally, the ability of PSBs to tap capital market on the strength of their balance sheets, is itself a moot question.

Banking was not in good shape even before Covid, and there are plenty of other reasons to worry about than only NPAs and capital — high operating costs, poor governance, low risk taking ability — to name only a few.

The writer is an independent financial consultant

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