The Hindu Business Line : The effect of credit growth on NPAs

FINANCIAL year 2004-05 has seen substantial growth in bank credit. As on March 18, 2005, the annual credit growth was 26.2 per cent against a much lower 16 per cent in the previous year. In this context, it is important to look at the trend in non-performing assets (NPAs) of banks.

NPAs are largely a fallout of banks' activities with regard to advances, both at the management and implementation levels (including overall controls by the top management), the credit appraisal system, monitoring of end-usage of funds and recovery procedures.

It also depends on the overall economic environment, the business cycle and the legal environment for recovery of defaulted loans. Since the overall environment is more or less same for all banks, non-performing loans of individual banks are mainly a result of management controls and systems put in place by them.

A bank with an efficient credit appraisal and loan recovery system will grow stronger over the years. Such banks have good management control and also inherent strengths in terms of a highly motivated staff, good checks and balances, which are further enhanced by a regulatory and supervisory system.

As the growth in advances is largely determined by the economic and business environment, such banks will be able to push their credit portfolio aggressively, especially when the economy is booming. Also, as such banks have a diversified credit portfolio, it would act as a cushion during economic downturns. This will result in lower NPAs, allowing them to grow stronger and even adopt a more aggressive growth strategy and, thereby, withstand marginally higher incidences of default.

However, a bank without inherent strengths will not be able to push their credit portfolio the way they want to. They are characterised by poor management control, inadequate credit appraisal and even low levels of motivation among the staff. When such banks push their advances portfolio, chances of their asset quality deteriorating are higher.

Since asset quality will be visible only after credit disbursal, which itself depends on the regulatory definition of NPAs, any deterioration will be reflected after a time lag.

Thus, banks without inherent strength will have higher NPA levels, especially when the economy has seen above average credit growth.

Factors affecting NPAs

General environmental factors: These include business cycles, the legal framework, ethical standards, the regulatory and supervisory system, and the political environment.

Bank specific factors: The credit appraisal system; credit recovery procedures; controls, checks and balances adopted by the top management; the risk management system in place; and the motivation level of staff.

Thus, for both healthy and not-so-healthy banks, asset quality after an above average credit growth has a major effect on NPAs. One way to capture the effect of deterioration in the asset quality is to consider cumulative growth rates of credit, which also captures the time-lag effect of credit migration.

A quick analysis (see Table 1) shows that high cumulative growth of advances (2000-01 over 1997-98) was followed by a spurt in NPAs in later years for a majority of the banks. Of the 18 banks with more than 80 per cent cumulative growth, 12 witnessed increased NPA levels.

While State Bank of Indore, Jammu & Kashmir Bank, Andhra Bank and UTI Bank reduced their NPAs in 2000-01 over 1999-00, United Western Bank, Global Trust Bank and ICICI Bank, among others, saw substantially higher NPA levels.

Such comparison may not be fully relevant now. Banks have managed to reduce their NPAs substantially over the years, thanks to higher provisions and an improved legal framework for pursuing bad loans.

Thus, while comparison with the past may not be fair, lessons from the past may not be inappropriate. Banks with an aggressive approach to credit growth may have to handle their advances portfolio with care, especially after a spurt in overall credit growth.

Given the cumulative growth in advances, which can be classified as low or high credit growth compared to an average `middle' growth, it may be appropriate to look at resulting NPAs, which can also classified as low or high, again as compared to an average or middle level NPA.

In statistical jargon, this could be viewed as an attempt to create 2 x 2 contingency tables, with one variable as cumulative credit growth and the other as NPAs. The classifications are based on average cumulative growth for each year.

To reduce the effect of outliers on classification, extreme observations are excluded while averaging. Such classification is done for four years from 2000-01 to 2003-04 on the basis of three years' cumulative growth of advances (Table 2).

From Table 2 it can be seen that banks fall in four categories along with number of years it appeared in the category. For instance, State Bank of India has low cumulative credit growth followed by low NPAs for all the four years from 2000-01 to 2003-04 and IndusInd Bank had high cumulative credit growth followed by low NPAs for 2000-01 and 2003-04.

Some major observations can be made based on Table 2:

Banks with high credit expansion followed by low NPAs are the ones with a good credit appraisal system in place and with ability to recover it.

It may be possible for a bank to perform well in this sense for one year, but not consistently.

Only HDFC Bank was able to perform this way over four years, that is, from 2000-01 to 2003-04. Jammu & Kashmir Bank and IDBI Bank have been in this category for three years.

Banks with high credit expansion followed by high levels of NPAs cannot perform consistently and they invariably fall behind; it is an unsustainable approach. Banks such as Development Credit Bank fall in this category.

Aggressive credit expansion along with non-recovery till 2001-02, forced it to substantially curtail its operations, ending up with low advance growth during 2003-04. Lord Krishna Bank has been in this category since 2001-02.

Banks with low credit expansion and low NPAs adopt a cautious approach towards credit expansion. And those that consistently belong to this category have low growth in advances, despite low levels of NPAs.

As per Table 2, only State Bank of India has been in this category consistently.

Perhaps, the credit market in India does not have the capacity to absorb the funds available. Sangli Bank, one of the old private sector banks, has been in this category for three years. Banks with comparatively larger balance-sheets, such as State Bank of Saurashtra and Bank of Baroda, were also members of this group for two years.

As mentioned, banks with low credit growth and high NPAs are the ones to be monitored. These banks may have to review their credit assessment and monitoring systems. Based on the four years, the banks commonly in this group are Dena Bank, Ganesh Bank of Kurundwad and SBI Commercial & International.

Further, for the last three years, Punjab & Sind Bank has been in this category. United Western Bank and erstwhile Global Trust Bank were in this category for two years. It is worth mentioning that United Western Bank had extended high credit despite having high NPAs during 1997-98 to 2000-01.

The common perception that listing of a bank in the stock market improves quality of management may not be always correct, as illustrated in the Dena Bank, United Western Bank and Global Trust Bank cases.

Also, ownership pattern does not necessarily have a bearing on performance of banks. Both private and government entities have appeared in the important categories discussed.

To conclude, higher than average credit expansion can further strengthen banks if there is a good credit appraisal systems, strict recovery procedures and overall checks and balances by the top management.

(The authors are in the Division of Banking Studies, RBI, Mumbai.)

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
At loggerheads with Left

Protecting farmers from world markets

Economy in pink, but concerns persist

Poverty in the US: Fact and fiction

From failure to success

BIS Platinum Jubilee report: `Build on financial stability'

The effect of credit growth on NPAs

Petrol price hike

Water conservation

Screen smoking