EE Project GRP 8 Report

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Did high instances of Bank NPAs in the last decade

constraint the effectiveness of monetary policy in


India?

A report submitted as part of course requirements for

ECONOMIC ENVIRONMENT

KHYUNKA DORJAY(389) | EESHITA BANSAL (378) | PUJA GOYAL (400)

RISHABH KUMAR (403) | ROHAN YADAV (404) | SIMRAN KERNI (412)

INDIAN INSTITUTE OF MANAGEMENT KOZHIKODE

DEC 2022 | TERM II | PGP 26


TABLE OF CONTENT

1. Introduction to the monetary policy of RBI and its goals 3

2. NPAs and Indian banking sector 4

3. Incidence of NPAs: The PNB Case and its effect 6

4. Effect of NPA on Banking Sector 7

5. Effect of NPA on Economic Growth 7

6. Effect of NPA on Monetary Policy transmission 8

7. Conclusion and the way ahead 9

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1. Introduction to the monetary policy of RBI and its goals

A country's central bank uses a collection of instruments and procedures known as monetary
policy to regulate the entire money supply and foster economic growth. The policies use both
long- and short-term tactics, altering bank reserve requirements and interest rates,
respectively. In order to promote maximum employment while containing inflation in India,
the Reserve Bank of India executes monetary policy with the below-mentioned objective(s) -

Goals of the Monetary Policy:

The policies have broadly three major objectives:

1. Price Stability or Control of Inflation - This is the primary and foremost aim of RBI’s
monetary policy. In a developing economy like India, the acceleration of investment
activity in response to supply shocks in the different sectors like agriculture tends to
be accompanied by price pressures, and thus, monetary policies have a significant role
to play in the short-term management of inflation.
2. Economic Growth - Monetary policies help define the availability of credit and thus it
can promote economic growth by ensuring that there is sufficient credit available
along with a lower cost of credit.
3. Exchange Rate Stability - Before 1991, India followed a fixed exchange rate system
with the occasional devaluation of INR in accordance to IMF. However, post the
liberalization of the economy, it has become supremely essential for the RBI to
contain depreciation and appreciation of foreign exchange rates in order to establish
and maintain exchange rate stability.

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2. NPAs and Indian banking sector

The relationship between non-performing loans (NPAs going forward) and bank losses is
established as reality in banking literature. Increased NPA rates are frequently associated with
credit policy failure as well. By looking at the bigger picture, it becomes clear that the
financial crisis is partly a result of the high NPA rate in the banking industry. The financial
crisis of the late 2000s, which began in the US and expanded to every country that had trade
links with the US, is also blamed for mortgage and loan defaults. The main cause of the
decline in bank earnings is an increase in the NPA rate.

Definitions of NPAs

According to the Reserve Bank of India, an asset, especially one that is leased, turns into an
NPA when it stops generating income for the bank.

Assets that have not been maintained for a while are typically considered as non-performing
by banks. The loan is considered past due if the payment was not made by the due date. Once
a payment is significantly beyond due, the loan is deemed to be non-performing. Loans or
advances with unpaid principal or interest for 90 days or more are classified as
non-performing assets (NPAs).

Classification of NPAs:
With effect from March 31, 2005, banks should classify non-performing assets (NPAs) in the
following way in accordance with RBI rules depending on the amount of time the asset has
remained non-performing and the realizability of the debt.

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Reasons for growing NPAs currently:
1. Government Issue
a. A company's use of borrowed money for reasons other than those for which it
was intended.
b. The original issuance of loans did not include any due diligence.
c. Ineffectiveness in the problem's post-disbursement monitoring.
d. Restructuring loans that banks had previously made to avoid provisioning.
2. Economic Reasons
a. The increase in bad loans since the economic slump of 2008
b. Because there is still little global demand, exports have been trending
downward across all industries for a while.
c. In the case of industries like electricity, the issue is the poor financial standing
of most SEBs, while in industries like steel, the drop in global prices suggests
that many more loans will experience stress in the months to come.
d. Over-leveraging by businesses was cited in the Economic Survey of 2015 as
one of the causes of an increase in bad loans.
3. Political reasons
a. The problem is also due to crooked capitalism.
b. Banks are required to offer loans for some particularly strained sectors due to
political pressure.
4. Problems of Exit
a. Without an appropriate bankruptcy law, businesses faced exit barriers that
caused a buildup of bad loans.
b. Corporates frequently choose the time-consuming legal route, which causes
issues for the banks.

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3. Incidence of NPAs: The PNB Case and its effect

PNB Scam

The fake letter of undertaking that the bank issued, worth Rs 10,000 crore, is at the center of
the Punjab National Bank scam.

The main people charged in the case were jeweler and fashion designer Nirav Modi, his
maternal uncle Mehul Choksi, and other family members and PNB employees. In the early
days of 2018, Nirav Modi and his family left India before the scam's revelations to the public.
The PNB scam has been called the largest banking fraud in Indian history.

At the PNB Brady House branch in Fort, Mumbai, bankers utilized fake Letters of
Undertaking (LoUs). Letters of Understanding (LoUs) were made for Indian bank branches
to import pearls for a year, with a total of 90 days from the date of shipping, as required by
the Reserve Bank of India.

Indian banks' overseas branches disregarded this directive. They didn't give PNB any of the
documents or information that the businesses had given them when they asked for credit.

Nirav Modi got his first false guarantee from PNB on March 10, 2011. Over the next 74
months, he was able to get 1,212 more false guarantees.

PNB filed an FIR with the CBI on January 29, 2018, alleging that fake Letters of Undertaking
worth Rs 2.8 billion (Rs 280.7 crore) were initially issued on January 16. Diamonds R Us,
Solar Exports, and Stellar Diamonds were the three diamond companies that PNB had listed
in the complaint.

As of May 18, 2018, the fraud has expanded to over Rs 14,000 crore. Employees of PNB sent
messages to Allahabad Bank and Axis Bank asking for money through the SWIFT network.
While using SWIFT passwords, all of this was accomplished without ever being logged in the
bank's core system, which kept PNB management in the dark for years.

Bank fraud not only affects the banking sector but also the whole economy. The impact of
PNB scam on Indian Economy are -

1. Banks and Jewelry sector stocks under pressure


2. Diamond business might shift from India to Belgium and Israel
3. Increase in difficulties for diamond businessmen for getting credit or loan from Indian
banks

The PNB scam adversely affected all of its shareholders, along with the government of India,
the banking industry, employees of PNB, citizens of India, etc. FII confidence and the
public’s trust are finished. The image and values of Indian public-sector banks and the

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diamond business have been denigrated. India’s ranking is degraded by global rating
agencies. These effects are so harmful for the Indian economy.

4. Effect of NPA on Banking Sector

We all know that banks are the engines that power the Indian economy. They accept money
from the public as a deposit and pay it back with interest. They lend the collected funds to the
general public and businesses at a higher interest rate than that offered to depositors. The
difference in interest or net interest income is used to fund the bank's operations.
When lent money becomes uncollectible, banks face a financial burden that affects their
overall operation. As a result, NPAs have a direct impact on the bank's performance.

Rising NPAs can have the following consequences:

- Rising NPAs damage the bank's reputation, causing the public to lose trust in banks.
Depositors may withdraw their funds, causing liquidity problems for the bank.
- Banks are unable to lend for other productive activities in the economy due to a lack
of liquidity. The reduction in investment may cause the economy to slow, resulting in
unemployment, inflation, a bear market, and so on.
- Banks will be forced to raise interest rates in order to maintain their profit margins,
further harming the economy.

5. Effect of NPA on Economic Growth

The rise in NPAs affects the banking sector and also poses a threat to the growing
economy.The slowdown in the economy due to the piling of NPAs affects businesses in all
sectors by curbing investments which in turn has an adverse impact on the economy and
stock markets.

Strong banking sector is one of the most significant prerequisites of a strong economy
because it channels the savings into the investment. A fragile banking sector will ultimately

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give way to the fragile economy.

It is clear that infrastructure accounted for the biggest chunk of NPAs. Because of the
massive amount of NPA in infrastructure, the banks are now reluctant to fund this sector. As
the infrastructure is one of the most important sectors in the economy which fuels the growth
of other sectors, draining of resources to infrastructure may hamper the growth of the Indian
economy.Among the other sectors, food processing also accounted for 5.3% of total NPAs.
Food processing is one of the most employment intensive industries and its growth also
pushes the growth of agriculture. Any loss to the food processing industry will ultimately
percolate to the employment as well as agriculture sector. Other sectors will also directly or
indirectly affect the overall economic scenario due to the exposure to the bad loans. Hence,
the issue of NPA must be resolved on an urgent basis.

6. Effect of NPA on Monetary Policy transmission

Since 2011, the asset quality of India's scheduled commercial banks (excluding regional rural
banks) has steadily deteriorated. 2 Following the withdrawal of regulatory forbearance on
restructured advances on April 1, 20153, and the asset quality review (AQR) in July 2015, the
pace accelerated. This resulted in a significant increase in the NPA ratios of domestic

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commercial banks, both public and private, rising from 3.4 percent of gross advances in
March 2013 to 4.7 percent in March 2015, and then to 9.9 percent in March 2016.

According to the empirical literature on the determinants of NIM, there is no agreement on


the direction and importance of the relationship between bank-specific variables and NIM.
The relationship varies across countries, bank groups, and over time.

According to the findings of the preceding analysis, asset quality has a significant impact on
monetary transmission in India. With a low gross NPA ratio, banks were able to pass on the
burden of asset quality deterioration to their borrowers in the form of higher lending rates,
which was reflected in an increase in NIM. Due to competitive pressures, banks were unable
to raise interest rates further as the gross NPA ratio increased. Banks, on the other hand, may
have made provisions for bad assets and may not have been permitted to recognise interest
income on such assets. All of this contributed to the decline in NIM.

7. Conclusion and the way ahead

A high rate of loan default undermines public faith in the integrity of the banking system and
indirectly affects the ability of the banking system to absorb deposits. It undermines the
confidence of the financial system (Gupta, 1999). Lower level of NPAs aids the banks in
cementing their position and offers credibility to effectiveness of the management. Moreover,
if a bank's profitability ratios are equivalent to international norms, it will get a higher rating,
a better rate for the equity and debt instruments it offers, slimmer margins for foreign
borrowings, and a better alliance. On the other hand, their balance sheets get weaker and less
competent as NPA levels increase. So tough steps are necessary at RBI, banks and judicial
level to handle this situation.

Higher levels of non performing loans have repercussions for the economy as a whole, not
just for the banks. Afraid of default, banks are not investing sufficient capital in lending. As
soon as lending to diverse sectors of the economy decreases, the economy is severely
impacted. There is a slowdown in the development of the gross domestic product, industrial

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production, and corporate profit margins, leading to a market depression. Further high levels
of nonperforming assets might increase the inflationary potential of the economy and weaken
the credit system as a whole.

There are two types of measures necessary to regulate the NPAs. Preventive steps are
essential to halt the new inflow of NPAs and curative measures are required to recover the
money out of assets which have already fallen into NPA category. Banks need to guarantee
that only real bids are approved and projects with inherited vulnerabilities are rejected at the
first instance. They need to strengthen their very weak credit evaluation abilities. The
borrower's economic viability, technical feasibility, managerial quality, and financial status
must be analyzed accurately. Banks must have an industry cell that gives them up-to-date
information regarding the industry's performance on a periodic basis. It is expensive for an
individual offer of appraisal to acquire such information. The industrial cell will be affiliated
with the corporate credit department. The purpose of credit information sharing amongst
banks is to exchange information about various debtors. After approving and disbursing
loans, the bank should carefully and intelligently monitor and manage the credit. After the
loans are approved, bankers believe their work is complete. They learn of the borrower's
predicament only after the default has occurred. If enough efforts are taken, it is possible to
predict the chance of default well in advance. They should employ effective credit monitoring
techniques. They should conduct frequent inspections of the units and get regular updates
from them on their financial areas, yearly accounts, and stock reports, among other things.

Establishing separate monitoring departments in major branches for periodic account


assessment, comparative risk analysis, and compliance with terms and conditions of sanction
may make credit monitoring more efficient.

Equally vital to reducing the load of NPAs on balance sheets are curative actions. Banks must
make earnest attempts to recover amounts from assets that have previously been classified as
non performing. The Recovery of Debt Due to Banks and Financial Institutions Act, 1993
created Debt Recovery Tribunals (DRTs) for the speedy determination of recovery cases
(1981). These DRTs are heavily loaded with cases. There is a need to establish more DRTs
and provide them with adequate infrastructure in terms of space, location, manpower support,

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and basic facilities, as well as to upgrade the legal framework, in order to expedite the
recovery of delinquent bank accounts, with a particular emphasis on foreclosures and
mortgages.
–x–

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