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Emerging crisis
The Q2 results published by banks seem to reinforce concerns over the health of the banking sector, specifically the level of NPAs that the system has accumulated.

Most banks have posted modest increase in operating profits. But NPA growth has continued its upward march and impacted profitability. IOB has actually posted a pre-tax loss due to increased provisioning.

NPAs operate like an economic law of karma for banks. First, they need to make increasing levels of provisions year on year out of operating profits and secondly, they cannot recognise income from the NPAs. What is worrying is the combination of factors at work here (a) absolute gross NPAs of the banking system have been rising steadily year on year, but exploded during FY2012 (50 per cent increase) and FY 2013 (36 per cent increase. (b) absence of viable recovery mechanisms.  SARFAESI and DRT have not proved useful in improving recovery ratios - less than 50 per cent of total bad debts are referred to them and even of this, recovery rate is only around 25 per cent. (c) Finally, the preferred option to manage NPAs, viz sale of NPAs to ARCs is also running out of steam.


No credible mechanism to deal with NPA

Worse still, we do not have a credible mechanism for dealing with the NPA problem. While asset reconstruction may be a successful method elsewhere in the world, this is largely due to the existence of strong and vibrant secondary markets for debt, as also an effective liquidation infrastructure. Both these are absent in India, which renders the ARC model a mere bookkeeping exercise. This is evident from the fact that very little cash is received. Also banks not only own most of the ARCs, but are also the largest subscribers of the SRs issued. This renders any effective transference of dubious risk. The SRs, euphemistically termed investments, are treated by banks as standard assets, since their value is derived from collateral and not on recovery record, as they earn little or no income. It is disconcerting to think that the reported levels of both standard and non-performing assets could actually be over-stated and under-stated respectively. The RBI is aware of this and to address the concern that banks do not use this option to evergreen their balance sheets, it has recently tightened norms of NPA sales, wherein 15 per cent of the asset sales needs to be paid to banks upfront. But this seems to have killed the appetite of ARCs for new purchases, as seen from the massive drop in business during Q2.

To understand the problem dimensions, we need to be aware of the extent of loan restructuring in the system. For nationalised banks alone, restructured advances as a percent of gross advances reached 8 per cent in March 2013, up from 4 per cent in March 2011.

The credit deposit ratio  mechanism also witnessed massive increase in restructured debt (growth of 52 per cent in 2012-13) touching over Rs.2.5 lakh crore.   The banking sector is at the cross roads today. Credit off-take is flat, net interest incomes are shrinking (since interest margins are low, it takes volumes to drive profits) and ability to provide for bad debts is thus impaired. Further, there is pressure to reduce interest. With the ARC route also becoming restricted, there is likely to be significant pressure on profitability of banks that are carrying large NPAs.

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