Indians have been reading about the abnormally high level of Non-Performing Assets (NPA’s) in the Indian banking system. But a layman often believes that he can not understand what exactly caused this problem. Moreover, the reality is often blurred by the political rhetoric. In this article, I will explain the problem in a simple, effective and objective manner.

Firstly, what is an NPA? I will not go into the technicalities of the definition. Simply put, NPA’s are loans given by the banks that borrowers are unable to pay back (principal as well as interest).

The Indian economy has seen a dramatic jump in NPAs from 3 percent of total assets in 2015 to 13 percent of total assets in 2018. In absolute terms, the number stands at 10.40 lack crores. In other words, banks have lost this money. Theoretically, they may get something by selling assets. But not practically.

This is sufficient to erode the ability of the Indian banks to finance future investment and is likely to hit job creation and growth for years to come.

Since this impacts your future as well as that of your children, it is important to understand the reasons behind this precarious situation. Different economists list different reasons. I strongly believe that when they attribute it to only one major reason, they are doing injustice to this complex problem. I think there are FIVE reasons behind this debacle and I will explain each of them.

It all began in 1997.

Yes, the story of irrational lending began in that year. Before 1997, the banks used to lend only working capital loans (short-term loans to run the daily business activities) to the Indian corporates. They never lent long-term loans to purchase assets. If they were not lending for assets, there was no chance for a non-performing asset. The long-term asset lending was done by Development Finance Institutions (DFIs). In 1997, the Indian government refused to finance DFIs with tax-free bonds and many had to shut shops. The Indian industry had to then resort to the bank loans.

Simply put, the Indian banking sector was not connected to long-term loans (that have recently turned into NPAs in the recent past) to the Indian industry in 1997. The seeds had been laid.

Germination and growth – 2002 to 2008:

The seeds germinated in 2002 when the government focused on the infrastructure projects with public-private-partnership. This led to a massive growth in project financing. The projects included roads, highways, power plants, etc.

I do not think this lending should only be criticised. It resulted in numerous benefits for the Indian economy. This phase led to the development of the road network in otherwise pothole infested Indian roads. This phase also led to the construction of numerous power plants in the country and once these plants became operational, India transformed from a power deficit country to a power surplus country. Remember, we export surplus power to Nepal, Bhutan, and Myanmar.

But how did the seeds germinate? Why did the borrowers default?

Well, certainly there was crony-capitalism at work in these dealings. The Public Sector Banks (PSUs) were under severe pressure from the government to lend money to its favorite businesses and, thus, the banks did not conduct proper due-diligence. However, not all cases can be attributed to favoritism. The times were good, the global economy was rocking, the demand was excellent. The banks, in an environment of exuberance, were ready to accept higher leverage in projects and lower promoter equity.

So far, so good.

The King Has No Clothes – 2008:

Then the global financial crisis happened with the collapse of the Lehman Brothers Bank in the United States. The global markets suddenly went into recession. Demand suddenly evaporated and exports based projects (in India) such as steel plants came under stress. The Indian economy, in general, suffered from low demand from consumers and the Reserve Bank of India (RBI) decided to inject liquidity in the system. In simple words, it decided to add more money into the system (the exact opposite of Demonetisation as done by the NDA government in 2016).

The government’s focus was to prevent any large account from becoming an NPA and this gave birth the practice of “Ever-Greening” at a massive scale.

What is evergreening? Let us assume you’ve borrowed a 100 rupee loan from a bank and you’re unable to pay it back. The bank wants to avoid officially calling you an NPA. So, the bank management and you will create an agreement. The bank will lend you 20 more rupees. Out of this money, you will pay some part as an interest to the old loan and some part as an interest of the new loan. Your net loan amount has increased. But you avoided being named an NPA account. Crooked! Isn’t it?

This evergreening continued from 2008 to 2015, when it reached to gigantic levels and the Indian banking system could not take any more burden. During this period, the banks simply delayed the inevitable. This had an adverse consequence since it ballooned the extent of the problem. This created a toxic, cancerous bubble.

Was global financial crisis the only reason?

NOPE! That will be too simplistic. Do you remember the Supreme Court judgment banning the allocation of coal blocks? Well, the power plants in India are mostly coal-based thermal power plants. Will the stroke of a pen, the supply to all plants was stopped and they suffered huge losses. Banks kept charging interest but the production was partly or completely halted. This was one of the reasons for NPAs in the power sector.

Summary:

The present situation on NPAs is a result of many internal and external factors. Not all were the cases of crony capitalism. Attributing it to corruption only and that too in one regime only will be an injustice to a thorough understanding of this problem. However, the government indeed committed errors of commission and omission and they should accept the mistakes and try to set the house in order.