ASSET QUALITY IN THE BANKING SECTOR

1. Background

• The banking system continues to suffer from shocks of asset quality woes.  The collateral damage caused by such a high volume of toxic assets impinges upon the overall efficiency of banks. 
• More so in public sector banks (PSBs) that have a larger share of bad loans. Whenever banks accumulate large toxic assets attracting the attention of stakeholders, the issue of hastening resolution comes to the centre stage of policy debate.
• Coming down heavily, the Economic Survey 2021 rightly attributed inefficient bank boards, poor governance structure and the failure of auditors to understand the “ever-greening” problem that added to the bad-loan mess. Besides recapitalising banks, enhancing governance in banks is held essential to improve the stability of the banking system. 
• Going by the experience of ever-greening, the survey suggested another round of asset quality review (AQR) after the current COVID-19-induced forbearance is phased out to assess the correct state of asset quality. 
• It also supported the idea of setting up a bad bank to rescue the banks in the near term.

2. Reason for stressed assets

Besides many interconnected factors, the reasons for the deterioration of asset quality of banks are a function of 

• quality of credit origination. It is linked to the autonomy in credit decisions, risk governance and effectiveness of systemic controls.  
• Intensity of post-sanction monitoring and follow-up of credit, the effectiveness of monitoring tools – the ability to sense incipient sickness. 
• Effective and speedy debt resolution ecosystem to hasten loan recovery and dissuade loan defaults. Its demonstrated impact should be able to transform the credit culture in society.   A deep dive into the state of these asset quality drivers can help identify the gaps.

3. Forward Outlook on Asset Quality

• Banks already loaded with high levels of bad debts are further stressed due to the impact of pandemic-induced challenges. 
• The potential large-scale rise in GNPAs in the coming fiscal year, 2021-22, needs to be tackled well with a multipronged strategy. 
• Granting additional loans and restructuring the existing loan facilities will provide borrowers with enough time to recoup from the ongoing stress.  
• While the RBI in its recent Financial Stability Report acknowledged that when the standstill clause in asset classification is lifted, banks will witness a rise in GNPAs to 13.5% by September 2021 in baseline stress that can slip to 14.8% in a severe stress situation.
• Looking at the extraordinariness of the ongoing crisis, while it is necessary to focus on near-term challenges, at the same time, banks should not lose sight of the long-term systemic approach to improve asset quality. 
• While all the stakeholders are working together to tackle near-term challenges, additional capital infusion and even setting up a bad bank could be a possibility.

4. Long-Term Approach and way forward

• Working out process reengineering of credit origination, monitoring and quick debt resolution can be an integrated long-term approach to improve the quality of assets in banks. 
• Going by the size of bank borrowers, collateralized loans: farm loans, retail loans, and MSME loans, many of them having an add-on cover of collateral securities, are large in numbers and low in value. 
• Whereas large loans and corporate sector loans, mostly secured by primary securities built with loan funds, are low in the number of borrowers but high in value.
• According to the size-wise distribution of borrowers, out of 27.25 crore bank borrowers in March 2020, only 6,79,034, much less than one crore borrowers have borrowed Rs 1 crore or more from banks sharing 56.3 % of total outstanding bank loans of Rs 105 trillion. 
• Loans of Rs 47.38 trillion are spread among 89,473 borrowers who have borrowed more than Rs 10 crore. 95.7% of borrowers have loan limits up to Rs 10 lakh. 77 % of borrowers have loans below Rs 5 lakh.
• The crux of the problem may be due to the engagement of banks in handling large numbers of loans of small value – less than Rs 10 lakh. 
• In an effort for equitable distribution of resources, banks may not be able to balance the interest of a few large-size loan accounts. 
• If the proportionality of focus on a few large loan accounts is ensured, the quality of the loan portfolio can improve.
• While improving credit appraisal and follow-up techniques, it may be necessary to earmark certain bank branches for small value loans while loans of Rs 1 crore and above are to be handled by a few branches where the compatible talent pool can be parked. 
• Even alliances with non-banks for small-size loans can be worked out so that more time can be devoted to large-size loans.
• Post-sanction scrutiny of borrowers' conduct and account operations need more attention. Technology can be better used to follow up loan accounts of Rs 1 crore and above with enhanced oversight to prevent the downgrade of loan accounts. 
• If due to any external or internal cause the account goes out of order, quick action to retrieve it can be planned.
• However best, the external legal ecosystem is improved, unless the credit origination and internal follow-up methodology of credit are improved, the asset quality standards cannot sync with best practices. 
• Unless credit quality improves, banks will not have enough latitude to compete in terms of risk-based pricing and market share. 
• Any temporary solution like the formation of a bad bank/alternative investment fund can be a band-aid and not a panacea against the ills of the present state of credit risk management in banks.