A Reserve Bank of India (RBI) study has said banks were unable to increase interest rates further when gross non-performing assets (NPAs) rose amid competitive pressures. The study has said deterioration in the health of the banking sector at the initial stages impairs monetary transmission through interest rate channel as banks are able to charge extra credit risk premium for possible loan losses. “However, when NPAs keep rising, banks are unable to protect their net interest margins (NIMs) due to competitive pressures, but they become risk averse and cut sharply their lending, which impacts monetary transmission through bank lending channel,” an RBI paper on ‘Asset quality and monetary transmission’ said. Banks have reported huge losses in the fourth quarter ended March 2018 due to high NPAs and provisioning. “At a low level of gross NPA ratio, banks were able to pass on the burden of deterioration in asset quality to their borrowers in the form of higher lending rates, which were reflected in increase in NIM,” it said. In contrast, banks might have made provisions for bad assets and also might not have been allowed to recognise interest income on such assets. All this resulted in the decline in NIM, the study has said. Banks in India, generally, charged additional premia to compensate for credit risk, which was reflected in their lending rates. This suggests that deterioration in asset quality did impact monetary transmission through higher NIM. Banks either utilised the higher spread to fund loan loss reserves (provisions) or to maintain their return on assets at the targeted level, the RBI paper said. Faced with higher NPA, the only option through which banks can maintain NIM at the baseline level as also the targeted RoA (return on assets) is by under-provisioning, i.e., keeping provisions at a lower than the prudent level (Scenario D). “By under-provisioning, banks can report artificially higher profitability. Banks can also camouflage NPA through loan restructuring as was done in India prior to the asset quality review. The reported figures of NPA and NIM then do not reveal the true health or efficiency of the banking system. Banks can continue to report healthy credit growth, but only through ‘ever greening’ or ‘zombie lending’. However, there is no ‘real’ monetary transmission in this case,” it said. Listing the implications, the paper said operating expense, as expected, was positively related to NIM indicating that less efficient banks, experiencing higher operating costs, require higher NIM. On the other hand, more efficient banks could reduce lending rates, and charge a lower NIM. “Second, as expected, non-interest income and NIM were negatively related indicating that banks with higher non-interest income were able to offer lending interest rates on better terms. Third, the capital adequacy ratio, which represents solvency, was found to have a positive relationship with NIM indicating that banks in India seek higher margins to compensate for higher cost of equity,” it said. Some of the studies, especially those pertaining to emerging market economies, show that the banks often lack pricing power and are unable to raise their NIM by loading higher credit risk premia, it said. “In that case, banks can raise their provisions to the prudent level only at the cost of a decline in bank profitability by an equal amount, the RBI paper said. “In this scenario, monetary transmission is not impeded initially as credit risk premia and hence, NIM remains unchanged. However, over the medium term, the decline in profitability can have implications for bank capital and that could constrain bank’s capacity to lend, particularly if the bank’s capital is at the regulatory minimum,” the RBI paper said. Thus, monetary transmission in this case could get impacted through the bank lending channel, it said. At times, banks may be compelled to make higher provisions and cover expected losses, and in the process, have to lower their profit expectations (RoA) as also their NIM. There may be an extreme case — the NPA situation is so grim that even after under-provisioning, banks may face lower return on assets and also a lower NIM. This situation is not at all inconsistent with an increase in the risk premia charged by banks. It only means that in a competitive market, banks cannot increase NIM by hiking the risk premia too high due to fear of losing customers and they are in such a financially precarious position that they are neither able to maintain their return on assets at the targeted level, nor make full provisions, it said. In India, asset quality of scheduled commercial banks (excluding that of regional rural banks) has deteriorated steadily since 2011. The pace accelerated following the withdrawal of regulatory forbearance on restructured advances effective April 1, 20153 and asset quality review in July 2015. “This resulted in a marked increase in the NPA ratios of domestic commercial banks — both public and private sectors — increasing from 3.4 per cent of gross advances in March 2013 to 4.7 per cent in March 2015, and further to 9.9 per cent by March 2017,” the RBI said. NIM of scheduled commercial banks (SCBs), which had declined from 3.0 per cent in 1999-2000 to 2.2 per cent in 2009-10 — the lowest in 2000s — increased to 2.9 per cent in 2010-11 before secularly declining to 2.5 per cent in 2016-17. Returns on assets/equity of public sector banks remained negative during 2015-16 and 2016-17.
