Provisioning for Non Performing Assets at Banks

K C Chakrabarty, a Deputy Governor at the Reserve Bank of India recently made a presentation on the credit quality at Indian banks (HT: Deepak Shenoy). In this presentation Dr. Chakrabarty talks about the deteriorating quality of credit in Indian banks, especially public sector banks.

What caught my eye as I went through the presentation, however, was this graph that he presented on “Gross” and “Net” NPAs (Non-Performing Assets). Now, every bank is required to “provision” for NPAs. If I’ve lent out Rs. 100 and I estimate that I can recover Rs. 98 out of this, I need to “provision” for the other Rs. 2 which I expect to become “bad assets”. Essentially even before there is the default of Rs. 2, you account for it in your books, so that when the default does occur, it won’t be a surprise to either you or your investors.

Now, NPAs are measured in two ways – gross and net. Gross NPAs is just the total assets that you’ve lent out that you cannot recover. Net NPAs are gross NPAs less provisioning – for example, if you expected that this year Rs. 2 out of Rs. 100 will not come back, and indeed you manage to collect Rs. 98, then your Net NPA is zero, since you’ve “provisioned” for the Rs. 2 of assets that went bad. If on the other hand, you’ve expected and provisioned for Rs. 2 out of Rs. 100 to be “bad”, and you manage to collect only Rs. 97, your “Net NPA” is Re. 1, since you now have Gross NPA of Rs. 3 of which only Rs. 2 had been provisioned for.

This graph is from Dr. Chakarabarty’s presentation, indicating the movement of total NPAs (across banks, gross and net) over the years:

Source: Presentation by K C Chakrabarty, RBI Dy. Gov. , via Capital Mind

What should strike you is that the net NPA number has always been strictly positive. What this means is that our banks, collectively, have never provisioned enough to offset the total quantity of loans that went bad. I’m not saying that they are not forecasting accurately enough – loan defaults are mighty hard to forecast and it is hard for the banks to get it right down to the last rupee. What I’m saying is that there seems to be a consistent bias in the forecast – banks are consistently under-forecasting the proportion of their assets that go bad, and are not provisioning enough for it. This has been a consistent trend over the years.

This fundamentally indicates a failure of regulation, on the part of both the bank regulator (RBI) and the stock market regulator (SEBI). That the banks are not provisioning enough means that they are misleading their investors by telling them that they are going to have lesser bad assets than actually are there (SEBI). That the banks are not provisioning enough also means that they are exposing themselves to a higher chance (small, but positive) of defaulting on their deposit holders (RBI).

How would this graph look like if the banks were provisioning properly?

The Gross NPA line would have remained where it is, for it doesn’t depend on provisioning. However, if the banks were provisioning adequately, the Net NPA line should have been hovering around zero, going both positive and negative, but mean-reverting to zero! This is because banks would periodically over and under-forecast their bad assets and provision accordingly, and then dynamically change the model. And so forth..

Read the full post by Deepak to understand more about our bank assets.

One thought on “Provisioning for Non Performing Assets at Banks”

  1. Karthik,

    “..net NPL is strictly positive. What this means is that our banks, collectively, have never provisioned enough to offset the total quantity of loans that went bad. ”

    That is a misleading statement. If you take 100 of homeloan that a bank considers is a NPL, gross NPL will be 100. However, the home loan is backed by a property which is worth something, say 70. Only 30 needs to be provisioned since it is the expected loss (ignoring foreclosure and legal costs). Therefore in this case net NPL = 100-30=70. So the expected losses are fully provided for even through net NPL is positive.

    “What I’m saying is that there seems to be a consistent bias in the forecast – banks are consistently under-forecasting the proportion of their assets that go bad, and are not provisioning enough for it. This has been a consistent trend over the years.”

    While your “banks are consistently underforecasting” statement may or may not be true, it cannot be argued by looking at positive net NPL. Only where banks do not expect to recover any money from defaulted loans and need to provision for the entire amount will net NPL be zero. The fact is that most bank lending is secured against assets, with a bulk of it against residential and commercial property which is worth something, therefore provisioning is almost always less than gross NPL leading to positive net NPL consistently. In fact a large bulk of any bank lending is residential mortgages where LTV starts out in the range of 60-85%, which means banks have higher collateral value compared to mortgage principal, hence recoveries tend to be high (many defaulted mortgages recovering 100% for example since as time passes principal reduces but property value may rise over the period reducing LTV, in other words, overcollateralisation increases).

    You say it is failure on the part of regulation. It is not – there is a “provision coverage ratio ” requirement which indicates at least some 70% (don’t remember the exact number) of gross NPL needs to be provisioned at the consolidated level. What is however hard and where there is room for improvement is the classification of loans as defaulted, forecasting future defaulted loans, firm resolution of loans in arrears through legal process (in India it can take years against corporate lending to recover money) and evergreening where loans that are expected to default are refinanced in advance at lower interest rates so that they do not default and do not have to be provisioned for. These are hard to detect as a regulator but something they worry about.

    Regards
    Rachit

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