One of the key functions of banks is to collect the savings of the society by way of deposits and transfer these to those who can use it productively by making loans and advances. This is the key transformation of capital which enables the society and economy to grow and prosper. This is known as financial intermediation and leads to an all-round win-win situation for the entire society - savers, borrowers, investors and the intermediary.
The main source of earnings for banks is interest earnings on loans and advances which is used to pay interest to depositors and the surplus is utilised first in meeting operating expenses and the balance, if any, is the profit.
A non-performing asset (NPA) is a loan or an advance where recovery of interest and / or principal has become uncertain. High and growing level of NPAs implies that there is uncertainty on the ability of banks to return the borrowed funds, leave alone pay the contracted interest on these deposits.
Keeping NPAs low for banks is critical for a number of reasons, which include:
First, NPAs deliver a double whammy to the bottom-line of banks by reducing the quantum of interest earned (main source of income for banks) while simultaneously having them to make provisions (from profits and if that is insufficient from capital) for the principal amount of bad loans.
Second, banks, being highly leveraged entities, have much less room to manoeuvre any fall in operating margins (i.e., the surplus of interest income over interest expenses—also known as net interest margin), something rising NPAs result in. As such, it is important that actual NPA levels are monitored and controlled regularly and closely—both by the banks themselves and the regulators.
Third, since the quantum of lendable funds is exponentially inversely proportional to the level of NPA, increasing level of NPAs reduce the lendable funds thereby affecting the liquidity services to the real economy.
This liquidity is the essential grease which keeps the economy moving and as it decreases income and employment opportunities in the real economy start getting curtailed.
Fourth, since banks make less income on the remaining portion of good loans the cost of the bad loans is passed on partly by charging higher interest on the good loans and partly by lowering the interest paid on deposits. Therefore, good borrowers have to pay higher levels of interest on their borrowings while depositors get a lower return on their savings!
Fifth, large and continuing incidence of NPAs results in losses and there is a limit to which promoters (government or private) would be willing and able to continue to fund such losses. Consequently there is reduction in the net worth of banks which has repercussions on banks to continue to offer their basic financial intermediation services. Therefore:
a) Credit rating of such banks falls, making it difficult for them to obtain / rollover lines of credit— especially overseas lines—thereby making overseas trade difficult and more expensive.
b) There is reluctance by overseas customers and counter-parties in accepting letters of credit (LCs) and guarantees issued by such banks – they have to be re-confirmed by other banks which, in turn, come at a cost leading to increase in cost of banking services.
c) Customers, especially large institutional depositors, hesitate to keep deposits in such banks.
d) Managers of such banks have fewer stakes in the continued well-being of banks as its equity keeps dropping which makes them take on higher and higher risks, pushing the entire economy into a much higher risk level.
Sixth, when banks start making losses and are unable to offer reasonable interest on deposits, the public starts looking for alternative avenues for parking their savings. These typically take two forms (a) physical assets such as land or jewellery, or (b) deposits in finance companies. The first may, at times, be a good inflation hedge but is prone to large variations in valuation, apart from being much less liquid. Moreover, these are not productive assets whereby the overall wealth of the society can increase. And, of course, our experience of money kept as deposits with finance companies has never been encouraging.
Finally, banks in their records hold the institutional memory of credit history of all the actors in the real economy. It is very hard and expensive to recreate this institutional memory once lost. When NPAs become so high that a bank becomes bankrupt and has to be closed down, this memory is as good as lost forever. This leads to a break in the payment / credit cycle to and from the various players in the real economy, which in turn, hits the real economy really hard by drastically reducing income as well as employment opportunities in the economy.
Therefore, it is in everyone's interest, and not just of the depositors, to ensure that our banking industry remains healthy.
(The author worked with various banks - public, private, and foreign both in India and abroad - for nearly 30 years and is currently on a self-imposed sabbatical to try and understand as to what ails Indian banking and what, if anything, can be done to improve its functioning.)