Assets as Liability?

: NPAs in the Commercial Banks of India

A Research Project Funded By South Asia Network of Economic Research Institutes

Meenakshi Rajeev Institute for Social and Economic Change Nagarbhavi, Bangalore-560072, India Ph: 080-23215468 Fax:080-23217008 Email: meenakshi@isec.ac.in

January, 2008

Non-Performing Assets in the Indian Banking Sector (with Special Reference to the Small Industries Sector)

By Meenakshi Rajeev Institute for Social and Economic Change Nagarbhavi, Bangalore-560072, India Ph: 080-23215468 Fax:080-23217008 Email: meenakshi@isec.ac.in

CHAPTER 1
INTRODUCTION 1.1 Introduction Financial resource is, no doubt, one of the most important inputs for economic development. Higher levels of financial development are significantly and robustly correlated with faster current and future rates of economic growth, physical capital accumulation and economic efficiency improvements (King and Levine, 1993a). The relationship between financial development and the economic growth has been established by various empirical studies ( see Adelman and Morris, 1968 and Goldsmith, 1969). It has been observed historically that banks formed the major part of financial system and thus played an important role in economic development. In India also financial system has been synonymous with banking sector. The importance of banking system in India is noted by the fact that the aggregate deposits stood at 55 percent of GDP and bank credit to government and commercial sector stood at 26 percent and 33 percent of GDP respectively in 2004-05. In the earlier stages of development, banking credit was directed towards selected activities only. For example, in the decade of 1960s, more than 80% of credit was to the trade and industry sector whereas agriculture and small manufacturing sectors were completely neglected. In 1969 nationalization of banks took place. At the time of nationalisation of private sector banks in 1969, the prime concern was to use resources available with these institutions for supporting the growth of priority sectors, viz. agriculture, small and village industries, artisans, etc., besides expanding the outreach to the poor. The assumption then was that credit could ensure faster growth. The planners adopted a supply side approach, which was possibly the need of the hour. The policy environment created at that time was primarily to pursue the agenda of social banking.

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The regulatory framework mainly focused on regulation of interest rate, preemption of resources, restricted investment avenue and expansion of banking network in backward areas. With multi-agency approach, banking network in the rural areas has made its formidable presence in providing rural financial services. The loans provided by banks have contributed substantially for the growth of all the priority sectors. Besides, the banking facilities were made available in unimaginable remote areas for tapping the latent savings of the rural masses. Though the volume of loans provided by banks has increased substantially, the health of these institutions also took a beating with increased thrust to financing under what is called directed lending and by implementing various government sponsored programs using banking as a channel of credit purveyor. At the time of carrying out general economic reform in the country a need to initiate financial sector reform was also been felt. Since 1991, the Indian commercial banks have undergone the reform process aimed at putting the Indian banking sector on par with international standards1. Performance in terms of profitability has become the benchmark for the banking industry like any business enterprise. In particular, due to the social banking motto of the Government, the problem of non-performing asset (NPA) was not considered seriously in India in the post nationalization (of banks) period. However, with the recent financial sector liberalization drive, this issue has been taken up seriously by introducing various prudential norms relating to income recognition, asset classification, provisioning for bad assets and assigning risks to various kinds of assets of a bank. While the Reserve Bank of India (RBI) as well as the banks have begun to pay considerable attention to the NPA problem, there are only a limited number of rigorous studies in the Indian context that look at this issue in some detail. In this project we attempt to look at the determinants of NPA (using a panel data model with a cross section of over 100 banks) by examining some of the external and internal factors like extent of competition, total assets of a bank, size of operations, proportion of rural branches , investment, etc., that can influence NPA. It is of our interest to examine, between various bank groups (viz, SBI,

One can see in this regard Charkavati Committee Report (1985), Narasimham Committee Report (1998), Basel I and II norms.

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Nationalized banks, Private banks and foreign banks), which is the most efficient group in the context of recovery of loans and what are the factors that determine this efficiency. For determining efficiency of the different banks in their loan recovery effort, the concept of technical efficiency will be applied, using a frontier production technique (Bettesse and Coelli (1995)). One of the important objectives of the nationalization of commercial banks in 1969 and in 1980 was to provide credit to till then neglected sector (what was later called the priority sector). Since them lot of effort has been gone in to chanelising credit to priority sector. One of the major components of the priority sector is the Small Scale Industrial sector. It has potential to generate substantial employment and also contribute in terms of production and exports. Unlike agriculture, there is no separate sub-target for the SSI sector, within the priority sector lending for the Indian public and private sector banks; and the share of credit to the SSI sector has been falling over the years in the post reform era2. This is a matter of serious concern as availability of credit has been always recognized as a constraint to the growth of the SSI sector, be it a women or a rural enterprise. Government has so far tried to mitigate the problem through various measures. However, one of the major concerns of banks is the problem of bad loans arising out of such small and medium enterprises (SME) accounts. While the problem of non-recovery of agricultural loan is a well-discussed issue (Bardhan, 1989, Bell and Srinivasan, 1989), not many studies in India have focused on the non-recovery of loans from the SSI sector. Most authors usually touched upon this issue in passing amid other problems of the SSI sector. However, the recent figures show that amongst different sub-sectors within the priority sector, SSIs contribution is the highest in total NPA of the priority sector lending (Table3). It is also worth noting in this context that SSIs share in net bank credit went from 15.89 per cent in 1991 to 11.1 per cent in 2003, charting a steady decline. The share of SSIs in total priority sector lending (TPSL) decreased even more dramatically in a shorter span of time: it went down from 36.12 per cent to 26.1 percent. Thus, as expected, channeling the credit away from this sector appears to be the solution adopted by the banks (EPW Editorial, June 5, 2004).
2

See RBI Bulletin different issues.

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Thus in this research work it is of our interest to look at various aspects of the NPA problem arising out of this segment for the Indian banking sector. Given our interest in the commercial banks, to put the issues in perspective, we first look at the development and the change that have taken place in the Indian banking sector. 1.2 A Brief Review of Indian Financial System The financial system of any country consists of specialised and non-specialised financial institutions, organized and unorganized financial markets, financial instruments and services, which facilitate transfer of funds. Procedures and practices adopted in the markets and financial interrelationships are also part of financial system (Bhole, 1999). In India, the financial system has undergone a significant change over time in terms of size, diversity, sophistication and innovation. Now India has a well-developed financial system
3 with a variety of financial institutions, markets and instruments . The structure of the

Indias financial system is illustrated in Fig.1.1. Fig. 1.1 Structure of Indian Financial System

See Bhole (1999), Sen and Vaidya (1997) for a detailed discussion of Indias financial system.

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Indias Financial System*

Financial Institutions

Financial Markets

Banks

Other Financial Institutions

Money

Credit

Capital

Insurance

Mutual Funds

Development Banks

Commercial

Co-operative

Public

Private

RRBs

Domestic

Foreign

Reserve Bank of India (RBI) is the controller and supervisor of India's Financial System. Source: RBI

An important feature of Indias financial system (like any other developing country) is that, until recently a financial institution has largely been synonymous with banking4 (Table 1.1). At the time of independence India had a relatively weak economic base and financial structure. Savings and investment were relatively low and only two third of the economy was monetised5. And also flow of funds from outside was very meager and savings from corporate sector were low. At this juncture, savings were coming mainly from household sector. And banks played very important role in transforming these savings to investment in industries and other infrastructure development. The gross domestic saving which was 10% of GDP in 1950-51 increased to 15.7% in 1971-72 and to 25.6% in 1995-96 which further increased to 27.6% in 2001-02 and it was 32% of GDP in 2004-05. Table 1.1 : Major Balance Sheet Components of Financial Institutions (2004) (Rs. In Crores)

4 5

Jadhav and Ajit (1996-97) pp 311 Lumas.P.S. (1990) pp 390

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Banks Capital Total Assets Deposits Loans and Advances Investment 22348 (66%) 1975020 (85%) 1575143 (91%) 864143 (81%) 802066 (92%)

NBFCs 6131 130142 17946 91613 14298

State Cooperative Banks 1012 71806 44316 37346 23289

Central Cooperative Banks 4342 133331 82098 73091 35830

Figures in bracket represent the percentage of the total. Source: Report on Trends and Progress of Banking in India 2003-04

1.3 Development of Indian Banking sector Modern commercial banking made its beginning in India with the setting up of the first Presidency bank, the Bank of Bengal, in Calcutta in 1806. Two other presidency banks were set up in Bombay and Madras in 1840 and 1843 respectively. They were private shareholders' banks. These banks were amalgamated into the Imperial Bank of India in 1921, which was nationalised into the State Bank of India (SBI) in 1955. The Reserve Bank of India (RBI) was established in 1st April 1935 with the passing of the Reserve Bank of India Act 1934. Following Sen and Vaidya (1997) the evolution of Indian Banking sector in the postindependence era can be divided into three distinct periods. (I) 1947-68 saw the consolidation of Reserve Bank of India (RBI) in its role as the agency in charge of the supervision and control of banks. In this period Indian banking sector operated in fairly liberal environment. (II) The second period 1969-1991 marked its beginning with nationalisation of commercial banks and their dominance in the financial system (III) the third period starting with liberalisation (1992) of banking and financial sector. After independence, the major development in the Indian banking sector was the nationalisation of banks. The first to be nationalised was the Reserve Bank of India (RBI),

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the country's central bank from 1 January 1949. Then came the take over of the (then) Imperial Bank of India and its conversion into State Bank of India (SBI) in July 1955 and the conversion of seven major state owned banks into subsidiary banks of the SBI in 1959. In 1969, 14 major banks were nationalised and in April 1980 six more banks were nationalised. After nationalisation public sector banks followed two important policies. (a) Massive expansion of branches especially in rural and semi-urban areas and (b) Diversification of credit to till then neglected sector (priority sector lending). In the post nationalisation period there was a rapid expansion of banks in terms of coverage and also of deposit moblisation. The number of bank offices multiplied rapidly from 8300 in July 1969 to 59752 in 1990, which further increased to more than 62 thousand in 1995, and it was 71177 in 2006. This has reduced the population served per bank branch. The number of people served per bank branch reduced from 65 thousand in 1969 to 14 thousand in 1990 which, however has increased marginally to 16 thousand in 2006 when consolidation has been in progress. Also the total deposit increased from Rs 4646 crores in 1969 to Rs 323632 crores in 1994 and to Rs 2109049 crores in 2006. Some of the major aggregates of Indian commercial banks are presented in Table 1.2. Table 1.2 Major Aggregates of Commercial Banks in India (Real Values)
Number of Banks Total Bank Branches Population Per Branch (thousands) Deposit (Rs crore) Credit (Rs crore) Total Investment (Rs crore) Credit to Priority Sector (Rs crore) Priority Sector Credit as Percent of Total Credit Credit-Deposit Ratio 1969 89 8262 64 33025 25583 9674 3583 14 77.5 1990 274 59752 14 235292 142994 87578 56271 40.7 60.8 1995 282 64234 15 324246 177319 125097 58008 33.7 54.7 2000 2005 298 289 67868 70373 15 16 536371 1124098 285993 727556 196320 488697 98116 252216 35.4 53.3 36.7 62.6

st

Source: Trends and progress of banking in India, RBI

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The post-nationalisation period was also marked by the developmental role of the banks. Government used banking sector as the instrument to finance its own deficit6. The fiscal deficit to GDP ratio for the central government increased steadily from an average of 3.56% in the period 1971-76 to 8.29% in the period 1986-91. High Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are used in order to financed this. The CRR, which was 3.5% in 1962-63, increased to 15% in 1989-90 and SLR, which was 25% in 1964-65 increased to 38.5% in 1990-91. Along with high CRR and SLR, the operational freedom of the banks was curtailed with high priority sector lending of as high as 40% of the total lending in 1989-90. To keep the borrowing cost of the Government low, the interest rate on bank loan was fixed at lower than market rates. This affected profitability and the efficiency of banks. Further, owing to the dominance of the public sector banks there was no competition. Due to the expansionary policy followed by the RBI, the number of loss making bank branches increased, especially in rural areas, which whittled away resources of the banking industry. Due to all these factors, towards the end of 1980s banking industry was badly in need of reforms. In 1991, Indian economy faced a major balance of payment crisis. The foreign exchange resources had almost disappeared. The fiscal deficit was high and the inflation rate reached double digits. To overcome this crisis, Indian Government introduced many economic reforms, which included amongst others financial sector reforms. As with general reform private sector grew considerably and growth of the private sector made demands on financial resources, there was a need to overhaul the financial system. Financial sector reforms were introduced in 1992.

1.4 Financial Sector Reforms in India The financial sector reforms in India began as early as 1985 itself with the implementation of Chakravarti committee report. But the real momentum was given to it in 1992 with the implementation of recommendations of the Committee on Financial System (CFS) (Narasimham, 1991). The important recommendations of the CFS were; (i) Reduction in SLR (ii) reduction in CRR, payment of interest on CRR and use of CRR as the monetary policy instrument (iii) phase out of directed credit (iv) deregulation of interest
6

Sen and Vaidya (1997) pp 15

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rates in a phased manner and bringing interest rate on government borrowing in line with market-determined rates (v) attainment of Basel norms for capital adequacy within three years (vi) tightening of prudential norms (vii) entry of private banks and easing of restriction on foreign banks (iix) sale of bank equity to public (ix) phasing out of development institutions (x) Increased competition in lending between Development Financial Institutions (DFI) and a switch from consortium lending to syndicate lending. (xi) easing of regulation on capital markets combined with entry of foreign institutions. Almost all of the recommendations of the CFS have been implemented in a phased manner. In 1998 another committee, the committee on Banking Sector Reforms (BSR) (Narasimham, 1998) was constituted. The recommendations of the BSR committee have also been implemented in a phased manner. The important recommendations of the BSR are: 1. A minimum target of 9% Capital Risk-Adequacy Ratio (CRAR) to be achieved by the year 2000. The ratio should be raised to 10% for the year 2002. 2. A risk weight of 5% for market risk for government-approved securities should be attached. 3. An asset to be classified as doubtful if it is in the category of 18 months in the first instance and eventually for 12 months and loss if it has been so identified but not written off. 4. Income recognition, asset classification should apply to government advances. 5. The minimum shareholding by government/RBI in the equity of nationalised banks and SBI should be brought down from 51% to 33%. Financial sector reforms can be broadly divided into reforms in financial institutions and reforms in financial markets. Reforms in financial institutions are mostly related to reforms in banking sector as the banking sector forms a very important part of financial sector. 1.5 Reforms in Financial Institutions

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Two main objectives of the financial sector reforms are to enhance the stability and the efficiency of financial institutions7. To achieve these objectives various reform measures were initiated which can be broadly grouped into three categories. 1. Enabling measures 2. Strengthening measures 3. Institutional measures Reforms in the commercial banking sector had two distinct phases. The first phase of reforms introduced subsequent to the release of the report of the CFS (1992) focused mainly on enabling and strengthening measures. The second phase of reforms introduced subsequent to the recommendation of the BSR (1998) committee report.

1) The enabling measures: These were designed to create an environment where financial intermediaries could respond optimally to market signals on the basis of commercial considerations. Salient among these include reduction in statutory preemption so as to release greater funds for commercial lending, interest rate deregulation to enable price discovery, greater operational autonomy to banks and liberalisation of the entry norms for financial intermediaries. (a) Reduction in statutory pre-emption: This includes reduction in CRR and SLR. These are mainly used to finance the fiscal deficit of the government and are also used as tools of credit control. At one stage CRR applicable to incremental deposit was as high as 25% and SLR was 40% thus pre-empting 65% of incremental deposits. These ratios were reduced in a series of steps after 1992. The SLR was 25% and CRR was as low as 5.5% in 2002 and now less than 5% of the total deposit. However, though the SLR has reduced to a much lower level, banks (especially public sector banks) hold government securities more than prescribed level. (b) Interest rate liberalisation: Before 1991, interest rates, both on deposits and loans were controlled by RBI. With effect from October 1997 interest rates on all time
7

RBI (2001-02)

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deposits have been freed. Only rates on saving deposits remain controlled by the RBI. Similarly the lending rates were also freed in a series of steps. The RBI now directly controls only interest rates charged on exports and also there is a ceiling on lending rate on small loans up to Rs 2 lakhs. The rationale for liberalising interest rate in the banking system was to allow banks greater flexibility and encourage competition. (c) Increased autonomy and competition: Banks have been given more autonomy by reducing government's stake in it. It was recognised that restoration of health of the banking system was required. Restoration of net worth was achieved through capital infusion from budget. Competition has been infused by allowing new private sector banks and more liberal entry of foreign banks (at the end of march 2001, there were 8 new private sector banks, 23 old private sector banks and 42 foreign banks as against 23 foreign banks in 1991). 2) The strengthening measures: These (also called prudential norms) were aimed at reducing the vulnerability of financial institutions in the face of fluctuations in the economic environment. These include various prudential norms related to capital adequacy and risk-weighted assets, income recognition, asset classification and provisioning for bad assets (NPAs). Following the CFS report the capital adequacy ratio was fixed at 8%. It was increased to 9% following the BSR recommendation. Financial institutions are asked to assign a risk weight of 100% on those government guaranteed securities, which are issued by defaulting entities. Further, due regard should be paid to the record of particular government in housing its guarantees while processing any further requests for loans to PSUs on the strength of that state governments' guarantees. 3) Institutional measures: These measures are aimed at creating an appropriate institutional framework conducive to development and functioning of financial markets. These measures include reforms in legal framework, particularly relating to banks. Banks are allowed to close down loss making units and merging with other banks. Flexibility is introduced in resource mobilisation. Financial institutions are not required to seek RBI's approval for raising resources by way of bond/debentures (by public/private placement). In order to have a coordinated approach in the recovery of large NPA accounts, as also

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for institutionalising an arrangement for a systematic exchange of information in respect of large borrowers (including defaulters and NPAs) common to banks and Financial institutions, a standing committee was constituted in august 1999 under the aegis of Industrial Development Bank of India (IDBI).

1.6 Non Performing Assets in India One of the important issues that is drawing attention of policy makers and researchers is the Non-Performing Assets of Commercial banks. High level of Nonperforming Assets (NPAs) is a concern to everyone involved as credit is very essential for economic growth and NPAs affect the smooth flow of credit. Broadly, Non Performing Advance is defined as an advance where payment of interest or repayment of installment of principal (in case of Term Loans) or both remains unpaid for a certain period8. In India though the issue of NPAs was given more importance after the Narasimham committee report (1991) highlighted its impact on the financial health of the commercial banks and subsequently various asset classification norms were introduced, the concept of classifying bank assets based on its quality began during 1985-86 itself (see Chapter 3). A critical analysis for a comprehensive and uniform credit monitoring was introduced in 1985-86 by the RBI by way of the Health Code System in banks which, inter alia, provided information regarding the health of individual advances, the quality of credit portfolio and the extent of advances causing concern in relation to total advances. It was considered that such information would be of immense use to bank managements for control purposes. Reserve Bank of India advised all commercial banks (excluding foreign banks, most of which had similar coding system in their organisations) on November 7, 1985, to introduce the Health Code classification indicating the quality (or health) of individual advances in the categories, with a health code assigned to each borrowal account. Under the above Health Code System RBI was further classifying problem loans of each bank in three categories i.e. i) advances classified as bad &

This time duration given for an asset to consider it as a NPA varies from country to country and can change over time within a particular country.

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doubtful by the bank (ii) advances where suits were filed/decrees obtained and (iii) those advances with major undesirable features. The Narasimham Committee (1991) felt that the classification of assets according to the health codes is not in accordance with the international standards. It believed that a policy of income recognition should be objective and based on record of recovery rather than on any subjective considerations. Also, before the capital adequacy norms are complied with by Indian banks it is necessary to have their assets revalued on a more realistic basis on the basis of their realizable value. Thus the Narasimham committee (1991) believed that a proper system of income recognition and provisioning is fundamental to the preservation of the strength and stability of the banking system. The committee suggested that Indian banks should follow the international practice in defining a NPA. Thus based on the recommendations of Narasimham committee report the non-performing assets would be defined as an advance where, as on the balance sheet date: 1. In respect of overdraft and cash credits, accounts remain out of order for a period of more than 180 days, 2. In respect of bills purchased and discounted, the bill remains overdue9 and unpaid for a period of more than 180 days, 3. In respect of other accounts, any account to be received remains past due for a period of more than 180 days.

The stricter regulations on NPA definitely reduced bad loans in the banks. Banks are now constantly being conscious of such accounts and proper measures are taken when an account has potential to become NPA10. The Gross NPA of the total banking industry has increased from Rs 50815 crores in 1998 to 70861 crores in 2002 which however has declined to Rs 58299 crores in 2005 (Table 1.3). Similarly the Net NPA has increased from Rs 23761 crores in 1998 to Rs 35554 crores in 2002 which however has declined to Rs 21441 crores in 2005. The growth rates of both Gross and Net NPAs also have
9

10

An amount is considered overdue when it remains outstanding 30 days beyond the due date. Revealed during our interviews with the banks.

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declined over time, and after 2003 they have become negative. This shows that the NPA levels of Indian commercial banks are reducing. This is also confirmed by the fact that the NPA (both gross and net) as percent of Gross advances as well as total assets is declining over time. While the Gross NPA as percent of gross advance and total asset has declined from 14.3% and 6.3% in 1998 to 5.2% and 2.5% in 2005 respectively, the Net NPA as percent of Gross advance and total asset has declined from 6.7% and 2.9% in 1998 to 1.9% and 0.9% in 2005 respectively. Table 1.3: Non Performing Assets of Total banking Sector Non Performing Assets of Total Banking Sector (Rs Crore)
Gross NPA Change Percentage growth As Percent of Gross Advance As Percent of Gross Asset Net NPAs Change Percentage growth As Percent of Gross Advance As Percent of Gross Asset Gross-net Change Percentage growth 1998 50815 1999 58722 7907 15.56 14.71 6.18 28020 4259 17.92 7.02 2.95 30702 3648 13.48 2000 60841 2119 3.61 12.79 5.49 30152 2132 7.61 6.34 2.72 30689 -13 -0.04 2001 63741 2900 4.77 11.42 4.91 32462 2310 7.66 5.82 2.50 31279 590 1.92 2002 70861 7120 11.17 10.42 4.62 35554 3092 9.52 5.23 2.32 35307 4028 12.88 2003 68717 -2144 -3.03 8.86 4.04 32670 -2884 -8.11 4.21 1.92 36047 740 2.1 2004 64787 -3930 -5.72 7.19 3.27 24617 -8053 -24.65 2.73 1.24 40170 4123 11.44 2005 58299 -6488 -10.01 5.27 2.57 21441 -3176 -12.9 1.94 0.95 36858 -3312 -8.24

14.39 6.36 23761

6.73 2.97 27054

Source: Report on Trends and Progress of Banks in India, various issues When we examine the sector-wise scenario we observe that NPAs arising from the SSI sector is comparatively higher than other sectors that fall even within the priority sector. From RBI report it is seen that in 2002, NPAs from agriculture loans was 13.8% and that of SSI was 18.7%. In 2004 NPAs arising from agriculture sector increased to 14.4% but still remained lower to that of SSI sector which was 17.6%. Thus directed credit to the priority sector in general and loan to SSI sector in particular remained major concern of the banks as far as NPA issue is concern. It is therefore of interest to look briefly at the credit to these segments.

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1.7 Directed Credit to Priority Sector 11 After independence it was felt that in order to achieve overall development of the country it is essential to develop the large rural sector, for which it is necessary to channelise required financial resources. In 1954 the All India Rural Credit Survey Committee found that not sufficient credit has been directed towards the rural sector of the economy. Thus the committee recommended for the development of state sponsored commercial banking system with branches spread in the rural areas. As a result of this a drive to nationalize commercial banks was launched. Thus one of the main objectives of nationalization of commercial banks was to provide credit to, what was considered as, priority sector. As lending to these sectors was not profitable for commercial banks they were not motivated to lend to these sectors. This was evident from the fact that the proportion of credit for industry and trade moved up, from 83 per cent to 90 per cent between 1951 and 1968. This rise was however at the expense of crucial segments of the economy like agriculture and that small-scale industry. Due to this reason commercial banks were directed to lend to these sectors by fixing targets. Apart from fixing targets of minimum credit, banks were also asked to lend to these sectors at a concessional rates. This was done to ensure that bank advances were confined not only to large-scale industries and big business houses, but were also directed, in due proportion, to important sectors such as agriculture, small-scale industries and exports. To begin with there was no target on the priority-sector lending. It was just emphasized that commercial banks should increase their involvement in the financing of priority sectors, viz., agriculture and small scale industries. However, based on the recommendations of the report submitted by the Informal Study Group on Statistics relating to advances to the Priority Sectors, the description of the priority sectors was later formalized in 1972. Later banks were advised to raise the share of the priority sectors in their aggregate advances to the level of 33 1/3 per cent by March 1979. Further it was increased to 40 percent at the end of 1985 and also sub-targets were fixed. During the initial period, only agriculture, small scale Industries, small and marginal farmers and
11

Priority sector comprises agriculture (both direct and indirect), small scale industries, small roads and water transport, small business, retail trade, professional and self-employed persons, state sponsored organizations for Scheduled Castes/Scheduled Tribes, education, housing (both direct and indirect), consumption loans, micro-credit loans to software, and food and agro-processing sector (Repot on Trend and Progress of Banking in India, 2005-06).

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artisans and exports were included in the priority sector. Later, based on the recommendations of Narasimham Committee Report (1991), housing, education, consumption, profession, I.T. Sector, food processing not falling under SSI, etc. were also included under the priority sector based. During 1989-90 the target of priority sector lending was fixed at 40 percent for domestic commercial banks. Within this there were sub-targets which included 18 percent to agriculture and 10 percent to weaker sections. For foreign banks the total target was 32 percent within which the sub-target was fixed at 10 percent to small scale industries and 12 percent to export credit. In 1991. Later Narasimham committee pointed out many problems related to priority sector lending, the important one being that a large part of NPA comes from priority sector lending. Thus the committee recommended reduction of priority sector target to 10 percent and expansion of the coverage of priority sector to include more sectors. However, the target of priority sector was not reduced but the definition of priority sector was expanded to include more sectors. Also a provision was made such that banks that cannot meet the priority sector targets can deposit funds in the financial institutions like National Bank for Agriculture and Rural Development (NABARD) under Rural Infrastructure Development Fund (RIDF) or some banks can do so in the Small Industries Bank of India (SIDBI) for lesser interest rates, which in turn will be lent out to the priority sectors. The distribution of gross non-food bank real credit to various priority sector is given in Table 1.4. Table 1.4 Distribution of Commercial Bank Credit to Priority (Rs Crore, Real Values)

Year 1991-92

Distribution of Commercial Bank Credit to Priority (Rs Crore, Real Values) Gross Nonfood Total Small Other Bank Priority Percent percent scale percent Priority Sector Credit of 2 to 1 Agriculture of 4 to 1 Industries of 6 to 1 Sector 1 2 3 4 5 6 7 8 144564 54121 37.437 21633 14.964 21625 14.959 10863

percent of 7 to 1 9 7.514

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1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

153862 145950 168793 186127 196111 210462 220324 244511 268250 291729 366226 411538 540426 720588

54612 53880 58632 61461 66214 72768 77650 85926 96517 105910 124983 149059 206203 261492

35.494 36.917 34.736 33.021 33.764 34.575 35.244 35.142 35.980 36.304 34.127 36.220 38.156 36.289

21878 21208 21916 22667 24528 25499 26852 28928 32454 36718 43422 51153 67703 88355

14.219 14.531 12.984 12.178 12.507 12.116 12.188 11.831 12.098 12.586 11.857 12.430 12.528 12.262

21947 22617 25256 26724 28040 31817 32848 34425 35004 34566 35671 37206 40318 46276

14.264 15.496 14.963 14.358 14.298 15.118 14.909 14.079 13.049 11.849 9.740 9.041 7.460 6.422

10787 10055 11460 12070 13646 15452 17950 22573 29059 34626 45890 60700 98182 126861

7.011 6.889 6.789 6.485 6.958 7.342 8.147 9.232 10.833 11.869 12.531 14.750 18.168 17.605

Source: Handbook of Statistics on Indian Economy The total priority sector credit of commercial banks was around Rs 54121 crores during 1991-92, which increased to Rs 96517 crores during 1999-2000 and it was Rs 261492 crores during 2005-06. It is observed that the priority sector credit has registered higher growth rate during the recent years. While it was around 6 percent for the period 1991-92 to 1999-2000, it increased to around 21 percent during the period 1999-2000 to 2005-06. This could be because the growth rate of the total credit itself has increased from around 7 percent during the period 1991-92 to 1999-2000 to around 20 percent during the period 1999-2000 to 2005-06. Though the growth rate of the total priority sector has been increasing over the years, similar trend is not observed in the case of the percent of priority sector credit in the total non-food credit. It was around 37 percent of total non-food credit in 1991-92, which declined to around 33 percent during 1994-95. This however has improved in the following years and reached around 38 percent during 2004-05, but again declined marginally to 36 percent during 2005-06. The increase in the percent of total non-priority sector credit in the total non-food credit is not substantial. It was around 35.14 percent during the period 1991-92 to 1999-2000 which increased marginally to around 36.17 percent during the period 1999-2000 to 2005-06. Looking at the growth rates of the sub-sectors of the priority sector; the growth rate of credit to agriculture and other priority sector are similar to that of the total priority sector credit, whereas the growth rate of credit to Small Scale Industries (SSI) shows a

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varying trend. The growth rate of the credit to agriculture sector was around 3.76 percent during 1991-92 to 1999-2000, which increased to around 20.7 percent during 1999-2000 to 2005-06. The growth rate of credit to SSI was around 6.06 percent during the period 1991-92 to 1999-2000 which has declined marginally to around 5.17 percent during the period 1999-2000 to 2005-06. However, the growth rate of credit to other priority sector has registered substantial growth over time. It was around 10 percent during the period 1991-92 to 1999-2000 which has increased to around 34 percent during the period 19992000 to 2005-06. Looking at the percentage share of credit to the sub-groups of the priority sector, it is observed that the credit to agriculture sector as well credit to SSI sector has declined over time where the credit to other priority sector credit has increased over time. The decline in the credit to SSI is sharper than the decline in the credit to agriculture sector. The share of credit to agriculture sector in the total non-food credit declined from around 15 percent in 1991-92 to around 12 percent during 2005-06, whereas the credit to SSI declined from around 15 percent in 1991-92 to around 6.4 percent during 2005-06. This decline is sharper in the last few years. On the other hand the credit to other priority sector has increased from around 7.5 percent during 1991-92 to around 18 percent during 2005-06. The increase in the share of priority sector credit could because of the substantial increase in the housing credit, as housing credit also forms a part priority sector credit. 1.8 Credit to SSI Small Scale Industrial sector is one of the important sectors in India for a number of reasons, prominent amongst them being the employment generation capability. Recognizing its potential in terms of the employment generation and the production, it has been give the priority sector status. During 1991-92 the total number of SSI units was around 68 lakhs which increased to around 119 lakhs during 2004-05. The total investment also increased from Rs 93555 crore during 1991-92 to Rs 178699 crores during 2004-05. Production, measured at constant price (1993-94 base) which stood at Rs 84728 crores during 1991-92 increased to Rs 251511 crores during 2004-05. Importantly the employment level which was around 158 lakh during 1991-91 almost doubled and

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reached 283 lakh by 2004-05. Similarly the total export increased from Rs 9664 crores during 1991-92 increased to Rs 86013 crores during 2002-03. The definition of Small Scale Industries in India is decided on the basis of the investment in plant and Machinery which has changed over time. During 1966 an industry was considered a SSI if its investment in the plant and Machinery was not more than Rs 7.5 lakh. This limit was increased to Rs 10 lakh in 1975. During 1998 the small scale industry was defined as an industrial unit having an investment in Plant and Machinery not exceeding Rs.1 crore for most of the 8000 products produced in the SSI sector and not exceeding Rs.5 crore in respect of certain selected reserved items. In 2006 with the introduction of Micro Small and Medium Enterprises Development Act, 2006 (MSMED Act), the definition of the SSI was further revised. Now, the small scale enterprises (engaged in manufacturing) are defined as units with investment in plant and machinery between Rs. 25 lakh to Rs.5 crore. Within the SSI sector there are a number of sub sectors including tiny industries sector, ancillary sector, khadi and village industries sector, women enterprises and so on12. According to the definition of commercial banks credit to Small Scale Industries include financing of small, micro and unorganized non-farm sector. As mentioned above, public and private sector banks have to lend 40 percent of their total credit to priority sector, and for foreign banks it is 32 percent. Unlike agricultural sector there is no fixed sub-target in the case of credit to SSI for public and private banks. However, foreign banks are expected to lend 10 percent of their total credit to SSI sector. If they fail to reach the target, the remaining amount should be deposited at the Small Industries Development Bank of India (SIDBI). The distribution of commercial banks credit to SSI sector is presented in table 1.5. Table 1.5 Commercial Bank Credit to Small Scale Industries
Total SSI Credit 1 21625 Growth Rate of 1 2 Total Non food Credit 3 144564 Growth Rate of 3 4 Total Priority Sector Credit 5 54121 Growth Rate of 5 6 Percent of 1 to 3 7 14.96 Percent of 1 to 5 8 39.96 Rs. 5

1991-92
12

There are certain types of industries/activities wherein investment on plant and machinery up to crores can also be registered under SSI category.

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1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

21947 22617 25256 26724 28040 31817 32848 34425 35004 34566 35671 37206 40318 46276

1.49 3.05 11.67 5.81 4.92 13.47 3.24 4.80 1.68 -1.25 3.20 4.30 8.36 14.78

153862 145950 168793 186127 196111 210462 220324 244511 268250 291729 366226 411538 540426 720588

6.43 -5.14 15.65 10.27 5.36 7.32 4.69 10.98 9.71 8.75 25.54 12.37 31.32 33.34

54612 53880 58632 61461 66214 72768 77650 85926 96517 105910 124983 149059 206203 261492

0.91 -1.34 8.82 4.83 7.73 9.90 6.71 10.66 12.33 9.73 18.01 19.26 38.34 26.81

14.26 15.50 14.96 14.36 14.30 15.12 14.91 14.08 13.05 11.85 9.74 9.04 7.46 6.42

40.19 41.98 43.08 43.48 42.35 43.72 42.30 40.06 36.27 32.64 28.54 24.96 19.55 17.70

Source: RBI The total commercial bank credit to SSI sector stood at Rs 21625 crores during 1991-92 which increased to Rs 26724 crores during 1995-95 which further increased to Rs 34566 crores during 2001-02 and it was Rs 46276 crores during 2005-06. Though there is an increase in the credit to SSI sector over the years in terms of absolute value, the annual growth rate shows a varying trend. During 1991-92 it was 1.49 percent which increased to 11.67 percent during 1994-95, with a sharp decline in following two years it again increased to 13.47 percent during 1997-98. However it has declined steadily and reached the lowest level of -1.29 percent during 2001-02. Later it has improved steadily and it was around 14.78 percent during 2005-06. Unlike the varying trend in the growth rate, the percentage share of SSI credit in the total non-food bank credit has declined over time. It was around 15 percent during 1991-92 which declined to 11.85 percent during 2001-02, which further declined to around 6.42 percent during 2005-06. The percentage share of credit to SSI in the total non-priority sector has marginally increased from 40 percent to 43.7 percent between 1991-92 and 1997-98 which, however, has declined steadily thereafter and reached around 17.7 percent during 2005-06.

1.9 Conclusion Controlling the occurrence of systemic banking problems is undoubtedly a prime objective for policy-makers, and understanding the mechanisms that are behind the surge in banking crises is of utmost importance in this regard. Amongst the problems faced by the banks of many developing nations, occurrence of non-performing assets (NPA) is a 205

prominent one. While the origin of the problem of high level of NPAs basically lies in the quality of managing credit risk and the extent of preventive measures adopted, various factors like real interest rates, directed credit or inflation rate can also effect the level of NPA. Analysis of factors that cause the ratio of NPAs to total loans to fluctuate, for selected Asian countries, (viz., Taiwan, Hongkong , Singapore and others) reveals that a high ratio of corporate loans to individual loans results in lower percentage of NPA (Wu et al, 2003). In the literature it has also been cited that the reasons why NPAs are created are sometimes systemic in nature and directly attributable to events such as real estate bubbles (Thailand and Indonesia) or a high proportion of directed lending (Krueger et al, 1999). The problem is significant for the Chinese banks as well and in order to deal with the mounting NPA problem in the Chinese banks, government constituted four asset management companies (Bonin and Huang, 2001). Thus NPA is a problem of banking sector of many developing nations which needs to be studied carefully.

In Indian financial system, an asset is classified as non-performing asset (NPAs) if the borrower does not pay dues in the form of principal and interest for a period of 180 days. However, with effect from March 2004, it has been decided that a default status would be given to a borrower if dues were not paid for 90 days. Further, if any advance or credit facilities granted by bank to a borrower becomes non-performing, then the bank will have to treat all the advances/credit facilities granted to that borrower as non-performing without having any regard to the fact that there may still exist certain advances / credit facilities having performing status. Due to the social banking motto of the Government, the problem of NPA had not received due attention in India in the post nationalization (of banks) period. However, with the recent financial sector liberalization drive, this issue has been taken up seriously by introducing various prudential norms relating to income recognition, asset classification, provisioning for bad assets and assigning risks to various kinds of assets of a bank. Overtime though NPA as a percentage of total advances have reduced, it still remains a concern for the Indian banking sector. While the Reserve Bank of India (RBI) 206

as well as the banks have begun to pay considerable attention to the NPA problem, there are only a limited number of rigorous studies in the Indian context that look at this issue in some detail (see Ghosh, 2005, Mor and Sharma, 2003, Rajaraman et al, 1999). Furthermore, while reform regulations attempt to streamline banking operations, norms of priority sector lending remains intact more or less. In particular, banks need to allocate 40% of their total credit disbursement to agriculture, small-scale industries and other such designated priority sectors. However, it is also well known that the small firms, besides generating manufacturing output and foreign exchange through exports, are also a major source of employment in a labour surplus economy like India. It is also understood that the lack of access to finance for working capital and new investment presents a significant constraints on the ability of small firms to carry out business and to expand (Gang, 1995). Thus it is essential to examine the problem of NPA arising out of advances made by banks to this sector. Therefore, at the macro level, there is a need to look at the determinants of NPA in the Indian banking sector by examining some of the bank specific as well as macro level indicators. At the micro level on the other hand, one needs to identify the sector specific factors responsible for non-recovery of loans. Given this back ground, in the current project, we attempt to look at the determinants of NPA by examining some of the external and internal factors like, the extent of competition, total assets of a bank, size of operations, proportion of rural branches , investments etc., that can influence NPA. It is of our interest to examine, between various bank groups (viz, SBI, Nationalized banks, Private banks and Foreign banks), which is the most efficient group in recovery of loans and what are the factors that determine this efficiency. To have a micro perspective of the problem, as a case study, we have taken up a field survey based exercise concerning the SSI sector to understand the actual workings of the loan recovery process and the associated problems. In particular, we are interested in

207

examining the factors that have influence on recovery of loans in this segment of the Indian economy. Given this background the report is arranged as follows. Credit being our main area of focus, we concentrate on this aspect in some detail in Chapter 2 , mainly focusing on the credit to the SSI sector. The issue of non-performing asset in the Indian banking sector is discussed in general with trends of NPAs in Chapter 3. In Chapter 4 we analyse data NPA of commercial banks in a panel framework to identify the determinants of NPA. This is done for the total advances and also for advances to the SSI sector. In Chapter 5 we concentrate on the efficiency issue. In particular we examine the profit efficiency of the Indian banking sector and in particular check for the significance of NPA as a determinant of efficiency. Chapter 6 and Chapter 7 are based on our primary data collection from small firms and banks respectively. A concluding section is presented at the end.

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CAHPTER 2 Credit Operations of Indian Banking Sector and Credit to SSI

2.1 Introduction Lending is the core activity of the banking sector. This is the activity through which a bank as a firm earns profit. To make credit available to all sections of the society, at the initial stages of development a need was felt for a wider diffusion of banking facilities, mainly the credit facilities (see also Chapter 1). This was due to the fact that at that time, when activities were left entirely to the banking sector, banking operations concentrated in selected locations and sectors; for example, credit for industry and trade were as high as 83% to begin with and moved up further to 90% between 1951 and 1968. Thus credit to some of the core sectors like agriculture or SSI, that were in dire need of financial assistance were not forthcoming from the institutional lending agencies like commercial banks. Consequently certain controlling measures were perceived as necessary at that time. By 1969, 14 major banks were nationalized and slowly lending norms for the specific , hitherto neglected sectors were formalized. By 1979 banks were advised to lend to the priority sector (which 209

includes agriculture and SSI sectors) to the tune of 33.33% of total credit. By 1985 this percentage was raised to 40%. While credit to the SSI sector is treated as a part of priority sector lending, no specific target was set for this sector for the Indian banks. For the foreign banks however, 32% of total lending is earmarked for the priority sector of which 10% is needed to go towards the small industries. Any short fall in such lending by foreign banks has to be deposited with the Small Industries Development Bank of India (SIDBI). With liberalization, new changes have been brought into the banking sector (see also Chapter 1). Efficiency in banking operations was given utmost priority and profit became a measuring yardstick of performance. Such new emphasis has slowly been changing the focus of the banking sector. In particular, there was a decline in the percentage of credit to the small-scale sector and it has been observed that the banks fail to adhere to the lending norms prescribed for the agriculture sector. Side by side rural branches also started to decline. In this background the present chapter looks at the current scenario of bank lending and in particular lending to the small-scale sector. The next section concentrates on the trends in bank lending over the years. Section 3 discusses the role of the small-scale sector for the Indian economy and the problems faced by the sector especially relating to the financial assistance. Section 4 examines the kind of credit facilities enjoyed by the sector especially from the commercial banks. A concluding section follows thereafter.

2.2 Credit Operation of Indian Commercial Banks Lending operations of the Indian commercial banks started much before independence. According to Beckhart (1967), from the 59 reporting banks in 1939, total advances were observed to be Rs 151 crores; thereafter there had been some fluctuations with regards to total lending . These fluctuations were usually due to the overall economic fluctuations at that time. In the year 1947 total loans and advances increased to Rs 425 crores As the economic activities gain momentum during plan-period, credit also shows an upward

210

trend with credit deposit ratio increasing to above 60% from about 40% to 50% in the previous years (table 2.1). Table 2.1 Loans and Advances of Schedule Banks 1939-1952 Year 1939 1942 1947 plan) 1952 91 Source: Beckhart (1967) 474 60 *loans and advances plus bills purchased and discounted No. of Banks 59 61 97 Reporting Loans and Credit* Advances (in crores ratio of rupees) 151 59 122 425.2 545.1 23.9 44 67 Deposit

1951(first 92

From 1961 onwards (third plan) there was always been an increasing trend of credit disbursement. Bank credit of scheduled banks increased to about 1320 crores of rupees and doubled by the year 1966-67. Such trend is due to the growth in economic activities in general and industrial activities in particular. By the year 1969, 14 major commercial banks were nationalised and the year 1970-71 saw a total lending of 4684 crores of rupees. This figure more than doubled in 1975-76 to reach Rs 10877 crores and this trend continued thereafter. In 1980-81 , total credit was Rs 25371 crores and the year 1985 saw an increase of credit disbursement to Rs 56067 crores. By the year 1990-91 total credit of commercial banks touched the figure of Rs 116301 crores.

2.3 Bank Group-wise Total Credit of Commercial Banks Indian commercial banks are classified into four broader categories, viz., State Bank and its associates (SB &A) , Nationalised Banks (NB), Private Banks (PB) and Foreign Banks (FB). The total credit of commercial banks, according to the bank group,

211

is presented in table 2.2. It is observed that even in real terms there has been a substantial increase in credit disbursement. The total bank credit (in real terms) of the banking sector as a whole was around Rs 169182 crores in 1990 which increased to Rs 175021 crores in 1995. While the extent of rise was not phenomenal during the first 5 years of reform, the next ten years saw substantial growth of credit. In particular, credit increased to Rs 277193 crores in 2000 and to Rs 589911 crore in 2005. Between 1991 and 2005 the total real credit increased by around 3.5 times. Similar trend is observed in the case of individual bank groups as well. The credit of State Bank of India and Associates (SB&A) increased from Rs 57004 crores in 1990 to Rs 146014 crores in 2005 (around 2.5 times), the credit of Nationalised Banks (NB) increased from Rs 98885 crores in 1991 to Rs 292279 crores in 2005 (around 2.9 times), the credit of Private Banks (PB) increased from Rs 5747 crores in 1990 to Rs 112993 crores in 2005 (around 19.6 times) and the credit of Foreign banks increased from Rs 7546 crores in 1990 to Rs 38625 crores in 2005 (around 5 times). Table 2.2 Bank group-wise total commercial bank credit Real Credit of commercial Banks (Real values, Rs crore)
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 SB&A 57004 58547 59081 58941 49044 53981 60945 60625 66102 70672 80653 90882 97212 106895 119198 146014 NB 98885 98274 98756 95957 85211 95013 100955 100442 109965 123143 139435 159681 186694 203473 222824 292279 PB 5747 5897 7065 7984 8968 13262 17453 20938 23998 27841 34842 41128 68768 77803 92100 112993 FB 7546 8483 10233 10641 10610 12764 17573 19563 19845 19233 22263 25983 28724 29475 32706 38625 Total 169182 171200 175135 173524 153832 175021 196926 201567 219910 240889 277193 317674 381397 417646 466828 589911 SB&A 0.34 0.34 0.34 0.34 0.32 0.31 0.31 0.30 0.30 0.29 0.29 0.29 0.25 0.26 0.26 0.25

Share of Total Credit

NB 0.58 0.57 0.56 0.55 0.55 0.54 0.51 0.50 0.50 0.51 0.50 0.50 0.49 0.49 0.48 0.50 PB 0.03 0.03 0.04 0.05 0.06 0.08 0.09 0.10 0.11 0.12 0.13 0.13 0.18 0.19 0.20 0.19 FB 0.04 0.05 0.06 0.06 0.07 0.07 0.09 0.10 0.09 0.08 0.08 0.08 0.08 0.07 0.07 0.07

SB & A: State Bank and Associates, NB: Nationalized Banks, PB: Private Banks, FB: Foreign Banks Source: RBI

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Another noteworthy feature is that though for obvious reasons nationalized banks and state bank and associates have shares over 80% of the total bank credit, over the years the share of private banks are increasing ; foreign banks share, however, has remained more or less the same during the liberalization period. This is partly because the new foreign banks that entered the market are yet to get stabilized and operate in a full-fledged manner . The percent annual growth rates of commercial bank credit, according to bank group are presented in table 2.3. The average annual growth rate of commercial bank credit of the total banking sector for the period 1990 to 2005 is 9.06 percent. This, however, as expected from the above discussion, differs at the bank group level. While the annual average growth rate of credit of SB&A is around 6.85 per cent, it is around 7.93 percent for NB and around 11.94 percent for FB. Private Banks have registered the highest annual average growth rate of around 22.83 percent for the period 1990 to 2005. It is also interesting to note 1990-1995. Table 2.3 Growth rates (percent increment) of credit of commercial banks (in real terms) that commercial banks, across all bank groups, have registered higher growth rate during the period 1995 to 2005 compared to the period

Growth rates of Commercial Bank Real Credit (in per cent)

SB&A 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2.71 0.91 -0.24 -16.79 10.07 12.90 -0.53 9.04 6.91 14.12 12.68 6.96 9.96 11.51 22.50 NB -0.62 0.49 -2.83 -11.20 11.50 6.25 -0.51 9.48 11.98 13.23 14.52 16.92 8.99 9.51 31.17 PB 2.61 19.81 13.01 12.32 47.89 31.60 19.97 14.61 16.01 25.15 18.04 67.20 13.14 18.38 22.69 FB 12.42 20.64 3.99 -0.30 20.31 37.67 11.33 1.44 -3.08 15.75 16.71 10.55 2.62 10.96 18.09 Total 1.19 2.30 -0.92 -11.35 13.77 12.52 2.36 9.10 9.54 15.07 14.60 20.06 9.50 11.78 26.37

213

Source: RBI

2.4 Total Credit of Commercial Banks According to Occupation Banks lending activities encompass various sectors of the economy. Naturally funds are directed to the so-called booming sectors. However, as mentioned above Indian financial sector is also guided by certain norms prescribed by the Reserve Bank of India (RBI), which ensures flow of funds to certain core sectors of the economy. Distribution of total credit according to occupation is presented in table 2.4. Looking at the different occupation-wise flow of funds one observes that credit to the agriculture sector has declined in real terms between 1990 and 1995. It was around Rs 22546 crore in 1990 which has declined to Rs 20910 crore in 1995. It should be mentioned in this context that banks are supposed to direct 18 % of their total lending to the agriculture sector ; however, in reality many banks often fail to meet this norm. Subsequently , however, total credit to the agriculture sector has increased and reached around Rs 49356 crores in 2004. In the case of other sectors the real total credit has been increasing over the years. Credit to industry increased marginally from Rs 68948 crores in 1990 to Rs 80639 crores in 1995 which further increased to Rs 171694 crores in 2004. There is a remarkable increase in the personal loans and also credit to financial institutions. While the personal loans increased from Rs 9083 crores in 1990 to Rs 15827 crores in 1995, it increased by around 5 times, from Rs 15827 crores to 91839 crores between 1995 and 2004. Similarly credit to financial institutions increased from Rs 3030 crores in 1990 to Rs 6664 crores in 1995 which further increased to Rs 20238 crore in 2004 (around 5 times). Table 2.4 Distribution of Outstanding Credit of Commercial Banks according to Occupation
Distribution of outstanding credit of commercial banks according to occupation (Rs in Crores, in Real values) Agriculture 22546 Industry 68948 Personal Loans 9083 Financial Institutions 3030 Others@ 37844 Total 141451

1990

214

1991 22129 70406 11436 3344 35900 147981 1992 22179 71467 12260 4385 39527 149818 1993 22060 78964 13530 3959 43954 162467 1994 20902 77390 13862 4166 44414 160734 1995 20910 80639 15827 6664 52758 176799 1996 22474 95374 18433 7031 55373 198684 1997 23134 102609 20623 8259 53333 207958 1998 23891 109144 23545 8291 58670 223541 1999 26652 122505 25805 10307 63998 249268 2000 28526 133624 32277 13672 79477 287576 2001 31261 142877 39848 15987 95407 325380 2002 37806 160431 48738 22216 118261 387452 2003 42901 175044 64374 28613 116169 427101 2004 49356 171694 91839 30238 108314 451442 @ Other include - Transport, personal and professional service, Trade and Miscellaneous

Computation of growth rates of real credit reveals that between 1995 and 2004 growth rates have been much higher compared to the same between 1991 and 1995. The average annual growth rate of real total deposits between 1991 and 2004 is around 8.61 per cent (Table 2.5). While it is around 5.08 percent between 1991 and 1995, it has increased to 11.06 percent between 1996 and 2004. Credit to agriculture sector has registered the lowest annual average growth rate of around 5.50 percent between 1991 and 2004. It was even negative between 1991 and 1995 (around -1.47 per cent per annum). However, it has increased substantially between 1995 and 2004 (around 10.05 per cent per annum). While on the one hand credit to agricultural sector has registered low growth rate, on the other hand personal loans and credit to financial institutions has registered remarkable growth rate. Between 1991 and 2004 personal loan has registered around 19.77 percent annual average growth rate, while it was around 20.32 percent in the case of credit to financial institutions. One important observation is that, unlike other occupations which registered higher growth rate between 1995 and 2004, credit to financial institutions registered higher growth rate between 1991 and 1995. it was around 22.35 percent during 1991 and 1995, which reduced to around 18.97 percent between 1995 and 2004. Table 2.5 Occupation-wise growth of outstanding Credit
Growth Rates of Outstanding Credit of Commercial Banks According to Occupation (Rs in Crores, in Real values)

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1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Agriculture -1.44 -1.85 0.22 -0.53 -5.25 0.04 7.48 2.94 3.27 11.56 7.03 9.59 20.94 13.48 15.05

Industry 10.47 2.11 1.51 10.49 -1.99 4.20 18.27 7.59 6.37 12.24 9.08 6.92 12.29 9.11 -1.91

Personal Loans 38.76 25.91 7.20 10.36 2.46 14.18 16.46 11.88 14.17 9.60 25.08 23.46 22.31 32.08 42.67

Financial Institutions 37.09 10.36 31.16 -9.72 5.22 59.98 5.50 17.46 0.39 24.33 32.64 16.94 38.96 28.80 5.68

Others -0.03 -5.14 10.10 11.20 1.05 18.79 4.96 -3.68 10.01 9.08 24.19 20.04 23.95 -1.77 -6.76

Total 7.24 4.62 1.24 8.44 -1.07 9.99 12.38 4.67 7.49 11.51 15.37 13.15 19.08 10.23 5.70

Source: RBI The difference in the growth rate of the real credit to different occupations has led to the changing composition of the credit according to the occupation. The percent share of real credit according to occupation is presented in Fig.2.1. On the one hand the share of the credit to industry and agriculture sector has declined between 1991 and 2004, on the other hand, as is clear from the above discussion as well, the share of the personal loan and credit to financial institutions has increased during the same period. The share of the credit to industrial and agriculture sector was around 48.74 and 15.94 percent respectively, which has subsequently declined to around 38.03 and 10.93 percent. And, the share of personal loan and credit to financial institutions was around 6.42 and 2.14 percent respectively in 1991 which increased to 20.34 and 6.70 percent in 2004. Fig 2.1 Percentage share of Credit of Commercial Banks According to Occupation

216

Credit of Commercial Bnaks According to Occupation (Per cent Share)

100%

80%

Industry Agriculture

60%

Per cent

Personal loans
40%

Financial institutions Others @

20%

0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

@ Other include - Transport, personal and professional service, Trade and Miscellaneous

2.5 Distribution of Total Credit : Rural and Urban Another important dimension of the commercial banks credit is the credit disbursement according to location (rural vs urban). Further, since in the post nationalization period, credit expansion to rural and semi-urban areas was given considerable importance, it becomes essential to look at the trends of the bank credit to these areas over time. Distribution of commercial bank real credit according to location is presented in table 2.6. Similar to the credit to different occupations, in the case of the credit to different population groups also the increase in the real credit is higher between 1995 and 2004 compared to the increase in credit between 1991 and 1995. The credit to rural sector increased from Rs 21789 crores in 1991 to Rs 22632 crore in 1996 (around 1.03 time), which further increased to Rs 56397 crores in 2005 (around 2.5 times between 1996 and 2005). Similar trend is observed in the case of credit to other population groups. Credit Semi-urban areas increased from Rs 24206 crores in 1991 to Rs 25961 crore in 1996 which further increased to Rs 66995 crore in 2005. Similarly, credit to urban and 217

metropolitan areas increased from Rs 31995 crore and Rs 63422 crore respectively in 1991 to Rs 32812 crore and Rs 99088 respectively in 1995 which further increased to Rs 97044 crores and Rs 370571 crores respectively in 2005. Table 2.6 Population group-wise Distribution of Outstanding Credit

Distribution of Outstanding Credit of Commercial Banks According to Population Group (in Rs Crores, in Real values)
Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Rural 21789 22160 22677 22906 22544 21100 22632 23785 25473 27435 30707 33157 38987 42452 45940 56397 Semi Urban 24206 24195 23671 23592 22438 23798 25961 27338 28699 31621 35351 37608 43157 48077 54124 66995 Urban 31995 33090 32486 33020 32778 32812 35184 36514 39301 44427 49814 57082 63293 71130 81232 97044 Metropolitan 63422 68536 70984 82949 82973 99088 114907 120321 130067 145785 173907 200145 238102 269364 294370 370571 Total 141411 147981 149818 162467 160734 176799 198684 207958 223541 249268 289779 327991 383538 431024 475665 591008

On an average percentage increment of credit from period 1991 to 2005 is around 6.34, 7.09, 7.62 and 12.46 for rural, semi-urban, urban and metropolitan areas respectively. It is important to note that between 1991 and 1995 the rural sector has registered negative annual growth rate of around -0.503 percent. For the same period the average growth rate is around 9.484 percent for the metropolitan areas. However from 1996 to 2005 growth rate of credit to all sectors is seen to be positive and increasing (Fig. 2.2). Fig. 2.2 Population group with percent increment in credit

218

Per cent Growth of Total Credit of Commercial Banks

30

25

20

15 Per cent Growth Rural Semi Urban Urban Metropolitan

10

0 1990 -5 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

-10 Year

Though there is increased growth rate of credit across all population groups, the difference in the growth rates led to change in the composition of credit to different population groups. The percent share of credit to different population groups is presented in Fig.2 3. As can be seen from the chart, the share of credit to rural areas in the total credit has declined over years, whereas the share of credit to metropolitan areas has increased. The share of credit to rural areas was around 15.08 percent in 1991 which declined to around 11.93 percent in 1995 which further declined to around 9.54 percent in 2005. Similarly the credit to semi-urban and urban areas was around 17.11 percent and 22.62 percent respectively in 1991 which declined to 13.46 percent and 18.55 percent respectively in 1995, which further declined to 11.34 and 16.42 percent respectively in 2005. On the other hand the credit to metropolitan areas has been increasing over time. It was around 44.8 percent in 1991 which increased to 56 percent in 1995 which further increased to 62.7 percent in 2005. Fig 2.3 Share of credit to different population groups

219

Distribution of Commercial Bank Credit According to Population (Per cent Share) 100%

80%

Rural
60% Per cent

Semi Urban
40%

Urban Metropo litan

20%

0% 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004
Year

We have seen so far trends of flow of credit to different regions of the economy as per rural or urban and also to major sectors like agriculture or industry. In this study however we are particularly interested in credit to the SSI sector. We therefore examine in some detail the flow of funds to the priority sector and within the priority sector to the SSI.

2.6 Sector-wise Distribution of Credit As mentioned above 40% of the total credit needs to be disbursed to the priority sector. It has been observed that initially banks were unable to meet this prescription. However, after liberalization a number of new avenues are incorporated within the purview of the priority sector. Subsequently, banks have been complying with the priority sector norms. At the sectoral level, credit to priority sector was around Rs 54121 crores during 1991220

2005

91 which increased to Rs 85926 crores during 1999-2000, and, reached Rs 261492 crores during 2005-06. Between 1991-92 and 2005-06 credit to priority sector has increased by around 4.5 times. Within the priority sector, credit to agriculture sector has increased from Rs 21633 crores during 1991-92 to Rs 88355 crores during 2005-06 (around 4 times). Much of the increase in the credit to agriculture is observed during last few years, especially during 2003-06. It is noteworthy that the increase in credit to small-scale industries, within the priority sector is much less compared to agriculture sector. It was Rs 21625 crores during 1991-92 which increased to Rs 46276 during 2005-06 (around two fold). Credit to industrial sector and wholesale trade increased from Rs 56105 crore and Rs 7332 crore respectively during 1991-92 to Rs 235291 crores and Rs 20362 crore respectively during 2005-06 (Table 2.7).

Table 2.7 Setoral Deployment of Non-food Credit

Sectoral Deployment of Outstanding Non-food Gross Bank Credit (Rs Crore, Real Values) Priority Wholesale Other Year Sector of which Industry Trade Sectors Total Small scale Agriculture Industries 1991-92 54121 21633 21625 56105 7332 27005 144564 1992-93 54612 21878 21947 64260 7637 27353 153862 1993-94 53880 21208 22617 57865 7330 26875 145950 1994-95 58632 21916 25256 68237 8909 33015 168793 1995-96 61461 22667 26724 77992 10041 36633 186127 1996-97 66214 24528 28040 80041 9626 40229 196111 1997-98 72768 25499 31817 85948 9665 42081 210462

221

1998-99 77650 26852 1999-00 85926 28928 2000-01 96517 32454 2001-02 105910 36718 2002-03 124983 43422 2003-04 149059 51153 2004-05 206203 67703 2005-06 261492 88355 *Medium and large # Other than food procurement

32848 34425 35004 34566 35671 37206 40318 46276

88426 96024 101782 104137 138898 139667 190435 235291

9461 10962 11154 12364 13335 14049 17594 20362

44787 51599 58797 69318 89009 108763 61640 102811

220324 244511 268250 291729 366226 411538 540426 720588

Growth rates of gross commercial bank credit to various sectors are presented in table 2.8. The average annual growth rate of gross non-food credit of commercial banks is around 11.3 percent. While the average growth rate of credit to priority sector is around 11 percent per annum, it is around 10 percent and 4.82 percent respectively for the agriculture and small-scale industries sector during 1991-92 to 2005-06. The average growth rate of credit to industry and wholesale trade are around 10.23 and 6.8 percent per annum respectively for the period 1991-92 and 2005-06. It is observed that the growth rates are higher during the period 1996-97 to 2005-06 compared to the period 1991-92 to 1995-96. The growth rates of credit to priority sector, industry and wholesale trade are around 1.24, 5.95 and 5.18 percent respectively for the period 1991-92 to 1995-96. This has increased to 15.95, 12.36 and 7.68 percent for priority sector, industry and wholesale trade respectively for the period 1995-96 to 2005-06.

Table 2.8 Percentage increment of Sectoral Deployment of Credit

Per cent Growth of Sectoral Deployment of Outstanding Non-food Gross Bank Credit (Rs Crore, Real Values) Priority Small Scale Wholesale Other Year Sector Agriculture Industries Industry Trade Sectors Total 1991-92 -7.00 -4.76 -7.18 -7.04 -8.51 -1.31 -6.08 1992-93 0.91 1.13 1.49 14.53 4.16 1.29 6.43 1993-94 -1.34 -3.06 3.05 -9.95 -4.03 -1.75 -5.14 1994-95 8.82 3.34 11.67 17.92 21.54 22.85 15.65 1995-96 4.82 3.43 5.81 14.30 12.71 10.96 10.27 1996-97 7.73 8.21 4.92 2.63 -4.13 9.82 5.36 1997-98 9.90 3.96 13.47 7.38 0.41 4.60 7.32 1998-99 6.71 5.31 3.24 2.88 -2.12 6.43 4.69 1999-00 10.66 7.73 4.80 8.59 15.87 15.21 10.98

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2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

12.33 9.73 18.01 19.26 38.34 26.81

12.19 13.14 18.26 17.80 32.35 30.50

1.68 -1.25 3.20 4.30 8.36 14.78

6.00 2.31 33.38 0.55 36.35 23.55

1.75 10.84 7.86 5.35 25.23 15.73

13.95 17.90 28.41 22.19 -43.33 66.79

9.71 8.75 25.54 12.37 31.32 33.34

The percentage share of gross non-food credit to various sectors, presented in Fig. 2.4 shows varying trend over the period. The share of credit to agriculture sector has declined from 37 percent during 1991-92 to around 33 percent during 1995-96 which however has increased to around 38 percent during 2004-05. On the other had credit to industrial sector has increased from 38.8 percent during 1991-92 to 41.9 percent during 1995-96 which declined to 32.6 percent during 2005-06. The percent share of credit to wholesale trade in the total gross credit has steadily declined from 5 percent in 1991-92 to 2.8 percent during 2005-06. Looking at the components of the priority sector credit, the share of the credit to agriculture sector as well small-scale industries has declined over time. However, the decline is sharp in the case of small-scale industries compared to agriculture sector. While the share of the agriculture sector in the total priority sector lending declined from around 40 percent in 1991-92 to around 33.7 percent during 200506, the share of credit to small-scale industries in the total priority sector credit declined from around 40 percent in 1991-92 to around 17.7 percent during 2005-06.

Fig. 2.5 Share of Gross Non-Food Credit

223

Percent Share of Gross Non-food Credit

50 45 40 35 30

Priority sector

Industry

Per cent

25 20 15 10 5 0 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

Wholesale trade

% of agriculture in total priority sector % of SSI in total priority sector

Year

Source: RBI This indeed is a matter of concern as the SSI sector plays a crucial role for the Indian economy in a number of aspects. By its less capital intensive and high labour absorption nature, small-scale industries (SSI) sector has made significant contributions to employment generation and also to rural industrialization, thereby helping in balanced regional growth. When the performance of this sector is viewed in terms of output as well as employment growth against other related sectors in the economy, one observes that the growth performance of the SSI sector is far higher than the large-scale industries sector and the manufacturing sector. Given this background we first discuss briefly the importance of the SSI sector in a labour surplus economy like India and the problems it faces for further growth and development. In this context credit related norms and issues are highlighted.

2.7. The Role of the Small and Medium Industries Sector 224

Small and medium industries sector is divided into various sub-sectors to come up with appropriate policy measures for each of them. Definitional Issues One of the difficulties in defining small firms is to identify what is small (Gang, 1995). One is often tempted to define small firms in comparative terms, that is, in comparison to the large firms in the industry. Brock and Evans (1986) suggest that one can consider those firms that lie on the left hand tail of the size distribution of firms, for example, say, in the bottom quartile as small. However, such relativistic definition has certain shortcomings. A firm that is considered large today may become small due to the entry of a few larger firms in the market. Thus there is a need to define smallness in absolute terms at least for the purpose of policy formation and implementation. Naturally, the definition can be on the basis of employment size, turn over, invested capital and so on. In the Indian context smallness is conceptualized on the basis of investment in plant and machinery. In India, a firm is considered to belong to the SSI sector, if its investment in plant and machinery does not exceed Rs 10 million ($ 250,000 approximately)13. Within the SSI sector there are a number of sub sectors including tiny industries sector, ancillary sector, khadi and village industries sector, women enterprises and so on14. Since the governments policy incentives differ across these sub sectors, there is a need to define them in precise terms. An ancillary industrial undertaking is a small enterprise as per the above definition and is engaged in the manufacture of parts, components, sub-assemblies, tooling or intermediates. On the other hand, a small scale service and business (industry related) enterprise (SSSBE) face investment limit up to Rs 1 million in fixed assets, excluding land and building. The tiny and village industries sector receive special attention of the government given their vulnerability and traditional importance. Hence the tiny, village & khadi15 and also women enterprises are specifically defined.
13 14

Source: Government of India website: http://www.smallindustryindia.com/ssiindia/definition.htm There are certain types of industries/activities wherein investment on plant and machinery up to crores can also be registered under SSI category. 15 A kind of traditional handloom.

Rs. 5

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Investment limit in plant and machinery with respect to tiny enterprises is Rs 2.5 million irrespective of location of the unit. A woman enterprise is the one that is owned or held more than 51% share by a woman. According to the Small Industries Development Organisation (SIDO), the term smallscale industry is used in the context of modern industrial units using a mechanized process or those engaged in the service sector. i.e, SSSBE. On the other hand, rural industries refer to village based semi industrial activities including the production of khadi, silk, coir etc. The coir sector is an agro-based industry relying on coconut fiber. The nodal agency for coordinating activities related to the SSI sector is SIDO, while for the Khadi and Village Industries Sector, it is the Khadi and Village Industries Commission and for the Coir sector, it is the Coir Board. Thus each of these sub sectors operate under a separate bureaucratic setup. Considering all enterprises viz., small, tiny and traditional village enterprises both in the registered and unregistered segments, there were about 6 million enterprises in 1990-91 which increased to about 10 million in 2004-05. Output of these enterprises at the 199394 prices was about rupees of 847 billions which increased to Rs 2515 billion in 20040516. Contributions to the Economy The small-scale industries sector plays a vital role in the growth of the country by contributing almost 40% of the gross industrial value added in the Indian economy.

Some of the major statistics concerning the small scale industries are presented in table 2.9. The number of total SSI units increased from 68 lakhs in 1990-91 to 83 lakhs in 1995-96 which further increased 1191 lakhs in 2004-05. Along with the number of units the fixed investment increased over time. It was Rs 93555 crores in 1991-92 which increased to Rs 125750 crores in 1995-96 which further saw a rise to Rs 178699 crores in
16

These estimates are from the Ministry of Small Scale Industries. (provided by www.indiastat.com).

226

2004-05. It is important to note that the fixed investment per unit has also increased over time. It was around Rs 13.78 lakh during 1991-92 which increased to around Rs 15.14 lakh during 1995-96, which however has declined marginally to Rs 15.06 lakh during 2004-05. Similarly the production of SSI, measured at constant price has also been increasing over time. It was around Rs 84728 crores during 1991-92 which increased to Rs 121175 crores during 1995-96 which further increased to Rs 251511 crores during 2004-05. The production per unit is also increasing over time. It was around 1.24 lakh in 1991-92 which increased to Rs 1.4 lakh during 1995-96 which further increased to Rs 2.12 lakh during 2004-05. Table 2.9 Major Aggregates of the SSI sector
Production No. of units (lakhs) Fixed investment (at current prices, Rs. crore) 93555 100351 109623 115795 123790 125750 130560 133242 135482 139982 146845 154349 162317 170219 178699 At current prices, (Rs. crore.) 78802 80615 84413 98796 122154 147712 167805 187217 210454 233760 261297 282270 311952 357733 418263 At constant price (1993-94 base, Rs crore) 84728 87355 92246 98796 108774 121175 134892 146263 157525 170379 184401 195613 210636 228730 251511 Employm ent (in lakh persons) Export (Rs.crore)

Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05

68 71 74 76 80 83 86 90 93 97 101 105 109 114 119

158 166 175 183 191 198 206 213 221 229 239 249 260 271 283

9664 13883 17784 25307 29068 36470 39248 44442 48979 54200 69797 71244 86013 NA NA

Source : Annual Report 2005-06, Ministry of SSI, Govt. of India We see from table 2.9 that the total number of SSI units has increased over time. Also the total fixed investment of the SSI, their production, employment level and exports have increased over time. However, their growth rates show a different picture. The growth rate of the number of SSI has remained almost stable around 4 percent per annum through the years. On the other hand the growth rates of investment in the fixed 227

assets show a varying trend. It was around 7.26 percent during 1991-92, which declined to around 1.68 percent during 1998-98, which however has increased thereafter and was around 4.98 percent during 2004-05. Contrary to this, the growth rate of the production of the SSI has increased from around 3.10 percent during 1991-92 to around 11.32 percent during 1995-96 which has declined to around 6 percent during 2001-03 which however has increased to around 10 percent during 2004-05. Similar to the growth rate of the number of units the growth rate of the employment level also has remained almost stable between 4-5 percent per annum over the years. The growth rate of the exports by SSI has declined steadily over time. It was around 43.66 percent during 1991-92 which declined steadily and reached the lowest level of around 2 percent during 2001-02 which however has improved and was around 21 percent during 2002-03. Table 2.10 Growth rate of certain indicators
Year 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 Units 4.07 4.08 4.05 4.07 4.07 4.07 4.06 4.07 4.06 4.07 4.07 4.07 4.07 4.07 Growth Rates Fixed Production Investment (Constant price) 7.26 3.10 9.24 5.60 5.63 7.10 6.90 10.10 1.58 11.40 3.83 11.32 2.05 8.43 1.68 7.70 3.32 8.16 4.90 8.23 5.11 6.08 5.16 7.68 4.87 8.59 4.98 9.96 Employment 4.83 5.33 4.46 4.80 3.41 4.01 3.55 3.47 3.88 4.20 4.44 4.36 4.31 4.11 Export 43.66 28.10 42.30 14.86 25.46 7.62 13.23 10.21 10.66 28.78 2.07 20.73

Jobless growth is a matter of concern for the Indian policy makers since liberalization. While large industries sector has not been able to create much employment opportunities, rather poor performance of the agricultural sector is also forcing the farmers to move out. Services sector and SSI sector in this regard give the economy some hope. In fact, SSI sector in India creates largest employment opportunities for the Indian populace, next only to Agriculture. It has been estimated that 100,000 rupees of investment in fixed 228

assets in the small-scale sector generates employment for four persons. Unlike the stagnation of employment observed in the large-scale sector, small industries employment reveals steady rise (Table 2.9 and 2.10). Industry group-wise food products industry has ranked first in generating employment, providing employment to 0.48 million persons (13.1%). The next two industry groups in terms of employment generation are non-metallic mineral products with employment of 0.45 million persons (12.2%) and metal products with 0.37 million persons (10.2%). Next to employment, forex reserve is Indias another important concern and the role of SSI sector cannot be undermined in this regard. The role of SSI Sector in forex earning through exports is well recognized17 (Table 2.11). Direct exports from the SSI Sector account for nearly 35% of total exports. Besides direct exports, it is estimated that smallscale industrial units contribute around 15% to exports indirectly. Thus in all, 45%-50% of the Indian exports is contributed by this Sector. This takes place through merchant exporters, trading houses and export houses. These may also be in the form of export orders from large units or the production of parts and components for use for finished exportable goods. While Indian small-scale segment is believed to be dominated by traditional goods, which attracts the foreign consumers, in reality non-traditional products account for more than 95% of the SSI exports. In particular, export growth has been fuelled mainly by the performance of garments, leather and gems and jewelry units from this sector. A few other product groups where the SSI sector dominates in exports are, sports goods, woolen garments and knitwear, plastic products and processed food. Further, the SSI sector is reorienting its export strategy towards the new trade regime being ushered in by the WTO. The total export of the SSI was Rs 9664 crores in 1991-92 which increased to Rs 36470 crores during 1995-96 which further increased to Rs 86012 during 2002-03. The per unit exports was around Rs 14 thousand which increased to Rs 44 thousand during

17

Source: www.smallindustriesindia.com

229

1995-95 which further increased to Rs 78 thousand during 2002-03. Share of Ssi in our total export is also considerable (Table 2.11).

Table 2.11 Share of SSI exports in India Total Exports Exports from SSI sector (in crores* of rupees) 155 766 2071 3644 13883 17785 25307 29068 36470 39249 44442.18 48979.23 54200.47 69796.5 71243.99

(in crores* of Year Percentage Share rupees) 1971-72 1608 9.6 1976-77 5142 14.9 1981-82 7809 26.5 1986-87 12567 29 1991-92 44040 31.5 1992-93 53688 33.1 1993-94 69547 36.4 1994-95 82674 35.1 1995-96 106353 34.2 1996-97 118817 33.4 1997-98 126286 35.19 1998-99 141603.53 34.59 1999-00 159561 33.97 2000-01 202509.7 34.47 2001-02 207745.56 34.29 *1 crore = 10 million. Source : Small Scale Industries in India, Ministry of SSI, Government of India.

When the performance of this sector is viewed against the growth in the manufacturing and the industry sector as a whole, it instills confidence in the resilience of the smallscale sector. Growth performance of the SSI sector is far higher than the large-scale industries sector and the manufacturing sector, as can be viewed from Table 2.12.

230

Table 2.12 Comparative real growth of overall industrial sector and SSI sector in India (1990-91 to 1999-2000) (in percent) Year 1990-91 1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 E Overall Industry 8.2 0.6 2.3 6 8.4 12.8 5.6 6.6 4 6.4 Manufacturing Sector 9 -0.8 2.2 6.1 8.5 13.8 6.7 6.7 4.4 7 SSI Sector 9.1 3.1 5.6 7.1 10.1 11.4 11.3 8.4 7.7 8.1

Abbr.: E : Estimated. Note : Estimated figures of growth for industry and manufacturing sector based on advance estimates released by Central Statistical Organisation. Growth rates from 1994-95 onwards are as per the IIP base 1993-94 = 100 and those for earlier years are as per IIP base : 1980-81 = 100. Estimation for the SSI sector for 1999-2000 made by SIDBI. Source : Report of the Study Group on Development of Small Scale Enterprises, Planning Commission, March 2001, Govt. of India. Year: Period of fiscal year in India is April to March, e.g. year shown as 1990-91 relates to April 1990 to March 1991.

The above indicators reveal that SSIs have made significant progress over the years and the sector has emerged as a dynamic and vibrant sector in the Indian economy. Industrial policy of the Government, both at the center as well as at the state level, have continuously tried to boost this sector in order to impart more vitality and growthimpetus.

Sickness in Small Scale Industries The Reserve Bank of India (RBI) was instrumental in appointing a number of Committees from time to time to look into the issue of sickness affecting this sector. The

231

latest definition of Sickness given by the Working Group on Rehabilitation of Sick Units set up by the RBI (also known as Kohli Committee) is given below.

A small scale industrial unit is considered sick when (a) any borrowal accounts of the unit remain substandard for more than six months or, (b) there is erosion in the net worth due to accumulated losses to the extent of 50 percent of its net worth during the previous accounting year, and (c) the unit has been in commercial production for at least two years. In order to measure incipient sickness, the continuous decline in gross output for three consecutive years was identified as a suitable indicator. Subsequently, the following criteria were adapted to identify sick/ incipient sick units in the third census: i) continuous decline in gross output compared to the previous two financial years; ii) delay by more than 12 months in repayment of loan taken from institutional sources; and iii) erosion in the net worth to the extent of 50 percent of the net worth during the previous accounting year.

Magnitude of Sickness/Incipient Sickness18

Sickness identified in the registered SSI sector in terms of delay in repayment of loan or erosion in the net worth was of the order of 2.5 %, whereas in the unregistered SSI sector, it was 0.78 %. Out of the units having outstanding loans with institutional sources like banks and financial institutions, sickness was about 14.08 % in the registered SSI sector as against 13.47 % in the case of unregistered SSI sector. Incipient sickness identified in terms of continuous decline in gross output was of the order of 13.01 % in the registered SSI sector and 7.76 % in the unregistered SSI sector according to 2001-02 census. Combining the three yardsticks used to measure sickness, viz; (a) delay in repayment of institutional loan over one year, (b) decline in net worth by 50 %, and (c) decline in
18

Source: Third All India Census of Small Scale Industries, 2001-02.

232

output during last three years, about 14.47 % of the units in the registered SSI sector were identified to be either sick or incipient sick, while this percentage was only 8.25 in the case of unregistered units. Reasons for Sickness/ Incipient Sickness In the census of 2001-02, the units satisfying one or more of the above criteria were treated as not being run satisfactorily and the reasons for the same were elicited. Table 2.13 indicates the reasons as given by the units suffering from sickness/ incipient sickness. Lack of Demand and Shortage of Working Capital were the main reasons for sickness, incipient or otherwise, in the SSI sector. Table 2.13 Reasons for sickness Reason Lack of Demand Shortage of working capital Non availability of materials Power shortage Labour problems Marketing problems Equipment Problems Management problems 21.4 7.4 44.5 10.6 5.5 14.8 5.1 41.2 12.9 5.1 Percentage of Units Registered 71.6 48 raw 15.1 Unregistered 84.1 47.1 15.2

*The total will exceed 100 %, as some units reported more than one reason. Source: Census of SSIs, 2001-02 As is observed, both registered and unregistered units face same problems that lead to sickness. Working capital related and Marketing problems (equivalently, lack of demand) are the major hurdles for the registered segment (that receives government support) as well as for the unregistered firms. The problem of working capital clearly shows that there exists a problem of credit for the SSI sector. This has been also revealed during our survey.

233

This led us to look at the credit policy of the SSI sector.

2.8 Credit Policy with Reference to SSI As mentioned above , at a time when there was no restriction on the lending activities of the banking sector, lending was directed to only a certain selected activities. To arrive at a desirable distribution of credit to core and socially important sectors, the concept of priority sector was developed. Subsequently, as mentioned above, at a meeting of the Union Finance Minister with the Chief Executive Officers of public sector banks held in March 1980, a decision was taken that banks should aim at raising the proportion of their advances to priority sectors to 40 per cent by March 1985. Following the recommendations of the Working Group on the Modalities of Implementation of Priority Sector Lending and the Twenty Point Economic Programme by Banks, all commercial banks were advised to direct 40 per cent of aggregate bank advances to the priority sector by 1985. In addition, there were sub-targets for lending to agriculture and to the weaker sections within the priority sector. These norms are undergoing modifications since then. In the decade of 1990s certain specific reforms have been brought in. The 40 per cent priority sector lending requirement for net bank credit (NBC) as applicable to PSBs as well as private sector banks continued, but liberalization of interest rate has been introduced on loans above Re. 2 lakhs. Few other areas are also incorporated within the purview of priority sector lending. Unlike agriculture, there is no separate sub-target for the SSI sector, within the priority sector lending for the Indian public and private sector banks. It is not mandatory for the Indian banks to deposit the shortfall in lending to the SSI sector with the Small Industries Development Bank of India (SIDBI) (as in the case of foreign banks) or any such organisation. Sub targets however exist for agriculture and loans to the weaker sections consisting of small and marginal farmers, artisans and others and they are 18% and 10% respectively. In the case of cooperative bank, 60 per cent of credit comes under priority

234

sector lending. In order to fulfill the priority sector lending targets, banks have been permitted to adopt soft approaches like subscription to the bonds of SFCs, NABARD, National Housing Bank, Rural Electrification Corporation, Housing & Urban Development Corporation, etc. instead of undertaking retail lending to the SSI Sector. Availability of credit was always recognized as a constraint to the growth of the SSI sector, be it a women or a rural enterprise. Government has so far tried to mitigate the problem through various measures. Few committees have been formed to understand and to come up with appropriate measures for this sector. In 1990 a separate financial intermediary called Small Industries Development Bank of India (SIDBI) was established. Since then SIDBI has been acting more as a small industries development organization rather than simply as a bank. Given the special role that the bank has come to play, some of its activities are considered worth noting. Role of SIDBI Promotional Programs: SIDBIs measures for this sector are modern in approach and intend to improve competitiveness in the sector. Some of its measures for example include:

Creation of awareness on new product / process technologies Skill upgradation Development of technology related common facilities for the cluster Provision of unit-specific modernisation package Energy conservation and introduction of environment friendly technologies Quality upgradation in terms of systems and products

It took a cluster development approach to take up various developmental measures. Cluster Development Approach: The first step in its approach to achieve these goals involves the selection of clusters, which have certain homogeneity in terms of status of technology, products, production levels, trade practices, and capacity to absorb improved

235

technology. Individual clusters are then assigned to expert consultancy agencies that assess the technology upgradation needs and prepare unit-specific modernisation packages including scope for consolidation of technical capabilities of existing units. Technology Upgradation Program: The competitiveness of the products of SSI units both in the domestic and international markets is dependent to a large extent on their productivity levels, price factors and quality characteristics. SIDBI's technology upgardation and modernisation programme are aimed at improving the technical capabilities and competitiveness of SSI units located in clusters by introducing commercially proven technologies which will result in significant improvement in quality, productivity, cost reduction, saving of energy and raw materials and reduction in the level of pollution.

Funding: SIDBI provides support and co-ordinates the services of consultants, and backs up their efforts by arranging financial assistance, through banks or State Financial Corporations (SFCs), under its refinance assistance schemes. The Bank also provides direct financial assistance through its Rs. 2 billion Technology Development and Modernisation Fund (TDMF) scheme. The Bank undertakes regular follow-up and monitoring of the programmes and the implementing agencies are suitably compensated by way of professional fee for undertaking the assignment.

Progress: The Bank in more than 25 clusters has launched technology upgradation program. The clusters identified for intervention range from Sea Food Processing Industry (Coastal Kerala) to Brass and Bell Metal Industry (Hajo in Assam) and from scientific instrument industry (Ambala, Haryana) to artisan based Blacksmithy units at Mylliem, Meghalaya and so on. In addition to this, the Bank is to implement the National Programme for Rural Industrialisation in 25 clusters of which 12 initiatives are already underway (www.sidbi.in).

236

Even though SIDBI has taken up various measures to aid the SSI sector number of SIDBI offices are limited and therefore they could reach only a small proportion of the SSI units. Rest of the sector still depends n various other sources for credit. Multi-level Financial Institutional Structure A large number of institutions are engaged in the task of credit dispensation to the small and other non-farm enterprises. Major national/state-level institutions operating in the country in addition to SIDBI are: Commercial Banks State Financial Corporations (SFCs) Regional Rural Banks Cooperative Banks Credit in Direct/indirect Form by Other Agencies. In addition to the creation of such specialized financial intermediaries, to improve credit flows to the SSI sector a few committees have also been constituted and in turn the Reserve Bank of India (RBI) has taken various measures . Focus and recommendations of few committees and RBI measures are discussed briefly below.

Nayak Committee This committee was formed under the Chairmanship of Ex-Deputy Governor, of RBI Shri R.R. Nayak, to look into the problems of credit, sickness and other relevant aspects of the SSI sector. The committee submitted its report in September 1992. Based on the Nayak Committee recommendations, Reserve Bank of India has directed the commercial banks to modify the definition of sick SSI units and to reduce rate of interest for rehabilitation. The committee has also suggested various rehabilitation packages.

237

Kapur Committee The Kapur Committee was set up by the RBI to review the working of the credit delivery system for SSIs with a view to making the system much more effective, simple and efficient to administer. The committee had also examined the sickness related issues of the SSI sector. For quick rehabilitation of sick SSI units, the Committee has recommended the following: Changing the definition of classifying the SSI unit as sick by reducing the nonperforming period of the SSI account from 2 years to one year. Converting State Level Inter Institutional Committees (SLIICs) into statutory bodies under a special statute to enable them to play effective role in rehabilitation of sick SSIs. Setting up branches of SLIICs in districts having large concentration of SSIs. Providing relaxation in income recognition and asset classification amounts to encourage banks to take up rehabilitation of potentially viable sick SSIs. Measures taken by Reserve Bank of India RBI has issued detailed guidelines vide their circular dated 17th April, 1993 and 3rd July, 1993 to banks for rehabilitation of sick SSI units including detection at the incipient stage and to take remedial measures, including the broad parameters for grant of relief and concessions such as: Interest on Working Capital 1.5 % below the prevailing fixed/PLR, wherever applicable Funded Interest Term Loan Interest free Working Capital Term Loan 1.5% below the prevailing fixed /PLR, wherever applicable. Term Loan Concession up to 2% ( Not more than 3% in the case of tiny/decentralised sector units) below the document rate. Contingency/Loan Concessional rates for working capital assistance. Assistance

2.9 Commercial Banks and Credit to SSI

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One of the important sources of credit to small-scale industries is the ercial bank. The total credit from commercial banks to SSI sector has increased from Rs 18939 crores in 1991-92 to Rs 34246 crores during 1995-96, which further increased to Rs 60141 crores during 2000-01 and to 90239 crores during 2005-06. Though at the absolute level, credit has been increasing over time the growth rate shows a varying trend. The annual growth rate of commercial banks credit to SSI sector increased from around 5.58 percent in 1991-92 to around 21.67 percent during 1994-95 which almost steadily declined thereafter and reached the lowest level of -3.58 percent during 2003-04. This however improved in the subsequent years. The credit to SSI sector as a percent of total net bank credit has been steadily declining over time. It was around 16.13 percent during 1991-92 which declined to around 15 percent during 1995-96 which further declined to 12.87 percent during 2000-01 and to 6.66 percent during 2005-06 (Table 2.14). Table 2.14
Flow of Credit from Commercial Banks to SSI (Rs crore) Credit to SSI Net Bank Annual Credit Annual as percent of Credit growth to SSI growth Net Bank Credit 117443 7.45 18939 5.58 16.13 141800 20.74 20975 10.75 14.79 152501 7.55 23978 14.32 15.72 192424 26.18 29175 21.67 15.16 228198 18.59 34246 17.38 15.01 245999 7.80 38196 11.53 15.53 297265 20.84 45771 19.83 15.40 339477 14.20 51679 12.91 15.22 398205 17.30 57035 10.36 14.32 467206 17.33 60141 5.45 12.87 535063 14.52 67107 11.58 12.54 668576 24.95 64707 -3.58 9.68 763855 14.25 71209 10.05 9.32 971809 27.22 83179 16.81 8.56 1354603 39.39 90239 8.49 6.66

1991-92 1992-93 1993-94 1994-95 1995-96 1996-97 1997-98 1998-99 1999-00 2000-01 2001-02 2002-03 2003-04 2004-05 2005-06

At the bank group level , the State Bank and Associates group also shows similar trend. There has been substantial decline of share of SSI credit in total priority sector lending (Table 2.15). This decline is even more striking for the private sector banks. Share of SSI credit in the case of Foreign banks however, remained more or less stable due to the

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special norms apply to them regarding priority sector lending. We recall that for the other bank groups there is no special norm fixed for the SSI sector separately.

Table 2.15 Bank GroupWise Advances to Small Scale Industries

Small Scale Industries (Rs Crore) Per cent to Total Priority sector credit Per cent to total non-food credit Small Scale Industries (Rs Crore) Per cent to Total Priority sector credit Per cent to total non-food credit Small Scale Industries (Rs Crore) Per cent to Total Priority sector credit Per cent to total non-food credit 1997 1998 1999 2000 Public Sector Banks 31542 38109 42674 45788 39.86 41.73 39.81 35.83 16.63 17.46 17.33 15.63 Private Banks 4754 5848 6451 7313 53.83 50.35 45.57 40.58 22.15 20.60 18.86 15.71 Foreign Banks 1836 2084 2460 2871 29.91 30.03 29.75 29.60 11.29 10.30 11.01 10.36 2001 48445 33.06 14.21 8158 37.86 14.40 3716 31.40 10.83 2002 49743 29.06 12.53 8613 33.50 13.70 4561 34.00 11.56 2003 52988 26.09 11.09 6857 18.68 8.29 3809 25.65 8.70 2004 58278 23.72 10.43 7897 14.94 7.08 5438 29.75 10.35

Diversion of credit away from the SSI sector may be due to the prevalence of sickness of the SSI units. If one examines carefully it is observed that the number of sick SSI units increased from 221472 in 1991 to around 268815 in 1995 (Table 2.16), which has declined thereafter to 221536 in 1998. After a sharp increase to 306221 in 1999, the total number of sick units has declined steadily thereafter and it was 138811 in 2004. However, the value involved in the sick SSI units increased steadily over the years. It was Rs 2792 crores in 1991, which increased to Rs 3547 crores in 1995 and further climbed up to Rs 4608 in 2000 and to Rs 5285 in 2004. Since on the one hand the number of sick SSI units is declining, and on the other hand the amount involved is increasing, the

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amount involved per units has increased steadily over time. It was around Rs 1.26 lakh per unit in 1991, which increased to Rs 1.74 lakh in 1998 which further increased to Rs 3.80 lakh in 2004. Though the total sick SSI units show a varying trend, the sick SSI units that are potentially viable are steadily declining over time. It was 16140 in 1991 that has declined to 15539 in 1995, which has further gone down to 14373 in 2000 and to 2385 in 2004. Unlike the case of total sick SSI units, the amount involved in the potentially viable sick SSI units has been declining over time. It was Rs 693 crores in 1991 which reduced to Rs 597.93 crores in 1995, which further declined to Rs 369 corores in 2006; One however, observe a marginal increase to Rs 421 crores in 2004. The amount involved per unit of the potentially viable sick SSI has steadily declined from Rs 4.29 lakh in 1991 to Rs 2 lakh in 1999, however, it has increased sharply there after and it was Rs 17.6 lakh in 2004. Table 2.16 Sickness in Small Scale industrial Sector
Total sick units Year No. Amount (Rs. Crores) Potentially viable Per cent of Potentially Viable in Total Sick Units No. Amount (Rs. Crores) 7.29 7.82 9.09 6.47 5.78 6.26 6.90 8.43 6.10 4.72 5.24 2.53 2.16 1.72 24.83 23.51 23.20 18.64 16.86 17.08 13.28 11.82 8.74 8.02 8.86 8.64 10.95 7.97

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Amount No.* Amount Amount Per unit O/s (Rs. Per unit (Rs Crores) (Rs Lakh) Lakh) 221472 2792 1.261 16140 693.12 4.294 245575 3101 1.263 19210 728.9 3.794 238176 3443 1.446 21649 798.79 3.690 256452 3680 1.435 16580 685.93 4.137 268815 3547 1.320 15539 597.93 3.848 262376 3722 1.419 16424 635.82 3.871 235032 3609 1.536 16220 479.31 2.955 221536 3857 1.741 18686 455.96 2.440 306221 4313 1.409 18692 376.96 2.017 1.515 2.570 304235 4608 14373 369.45 1.805 3.053 249630 4506 13076 399.17 2.717 9.268 177336 4819 4493 416.41 3.397 17.229 167980 5706 3626 624.71 3.807 17.660 138811 5285 2385 421.18 Source: Annual Report 2005-06; Ministry of SSI, Government of India *These units include village industries as well

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The major reason for the non performing assets arising from the SSI sector is their sickness. While there may be some proportion of willful default, unless one handles the sickness issue appropriately , reducing the bad loan from the sector becomes difficult. Banks will then take recourse to diverting their resources to other sectors in the economy. In the next Chapter therefore we discuss the NPA issue in general and that arising from the SSI sector in particular.

2.9 Concluding Remarks

The Indian banking sector has come a long way since the last century. Even since the nationalization of banks took place, the operations of commercial banks spread like never before. It covered all nook and corner of the nation. Accordingly credit disbursement and deposit mobilization have increased at a phenomenal rate. Various sectors especially agriculture sector was given priority in the lending of the commercial banks. Such norms have helped the sector to come out of the grasp of moneylenders to a large extent if not completely. Such social banking norms also however, have affected the financial health of the banks.

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With the liberalization of the Indian economy, various financial sector liberalization norms have also been introduced. These are aimed at improving the efficiency and profitability of the public sector banks. A number of reform measures have been introduced to provide autonomy to the banks (see Chapter 1). While the liberalized measures improved efficiency of the commercial banks, rural branches, credit share to some of the priority sectors such as SSI sector declined over time. It has often been argued that the NPA accounts mainly arise from the rural branches and priority sector loans. While there is some truth to these allegations, moving away from these sectors may not be an ideal solution for the economy. Further it is also important to ask whether these sectors alone need to be blamed for NPA? To examine this we devote our attention to the nature and extent NPA of the Indian commercial banks in the next chapter.

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CHAPTER 3

Non-Performing Assets of Indian Commercial Banks

3.1 Introduction High level of Non-performing Assets (NPAs) is a matter of concern for everyone involved as credit is essential for economic growth and NPAs affect the smooth flow of credit. Banks raise resources not just from fresh deposits, but they also create credit by recycling the funds received back from the borrowers. Thus when a loan becomes nonperforming, it affects recycling of credit and in turn credit creation. Apart from the credit creation, NPAs affect the profitability as well, since higher NPAs require higher provisioning, which means a large part of the profits needs to be kept aside as provisions for bad loans. Therefore, the problem of NPAs is not the concern of the lenders alone, but it a concern of policy makers as well who are involved in putting economic growth on the fast track. In India the concept of NPA came into existence after the financial sector reforms were introduced following the recommendations of the Report of the Committee on the Financial System (Narasimham, 1991). Broadly, Non Performing Advance is defined as an advance where payment of interest or repayment of installment of principal (in case of term loans) or both remains unpaid for a certain period19. In India, the definition of NPAs has changed over time. According to the Narasimham (1991) committee report, those assets (advances, bills discounted, overdrafts, cash credit etc) for which the interest remain due for a period of four quarters (180 days) should be considered as NPAs. Subsequently this period was reduced, and from March 1995 onwards the assets for which the interest has remained unpaid for 90 days should be considered as NPAs. NPA being our prime concern in this study we intend to look at the trends and nature of NPAs for the Indian economy in some detail in this chapter. However, before coming to

19

This time duration given for an asset to consider it as a NPA varies from country to country and can change over time within a particular country.

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the Indian scenario it is useful to examine the NPA problem for other nations across the globe to see where India stands vis--vis others.

3.2 NPAs at the Global Level In order to get a global picture it is essential to look at NPA levels of different countries in the world. Since the concept of NPA is developed in India only in the postreform era , it is useful to look at the recent figures rather than taking a historical account. A closer look at the Non-performing Loans (NPL) as they are called in many nations, reveals that during 2003 the NPL at the global level was US$ 1300 billion. India ranks fourth with NPL of around US$ 30 billion ( 2.3 percent of the global NPL), while Japan has the highest NPL of US$ 330 billion (25.4 percent of the global NPL) Turkey has the lowest NPL of US$ 8 billion (0.6 percent of global NPL, Table 3.1). Table 3.1 Global Non-performing Loans: 2003
Countries Japan China Taiwan Thailand Philippines Indonesia India Korea Germany Turkey Global NPLs (US$ billion) 330 307 19.1 18.8 9 16.9 30 15 283 8 1300 Share in Global (per cent) 25.4 23.6 1.5 1.5 0.7 1.3 2.3 1.2 21.8 0.6 100

Source: Global NPL Report 2004, Ernst and Young. Though one can get an idea about the magnitude of NPA by looking at the absolute values, it does not reveal the complete picture. This is mainly because absolute level of NPA depends on total advances. A country with larger population or GDP may have large advances and in turn NPA as well. Thus apart from the absolute value, it is also important to look at what proportion of the total loan has become non-performing. The NPL levels of various countries as per cent of their total loan are presented in table 3.2. It can be seen from the table that the NPA/NPL as a percent of total loans has been

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declining for almost all countries over the years. The average NPL as percent of total loans across the countries was around 11.89 percent in 2001 which has declined to around 6.44 percent in 2005. This shows that the quality of bank asset has been improving across countries over the years. This could be because of the stringent regulations prescribed by the BASEL norms. Examining the countries in terms of NPA as percentage of total loans, we observe that for around 16 countries NPA percentage is below 10 and for around 5 countries it is between 10-20 percent; for another 5 countries NPA percentage is rather high and above 20 percent. Australia has the lowest NPA to total loan ratio which is just 0.34 percent whereas Philippines tops the list with 25 percent. India attains the 11th highest position with around 8.6 per cent. One interesting observation is that, most of the countries which fall under higher NPL/Total Loan ratio category belong to the Asian region. Out of 10 countries which have this ratio above 10 percent 8 countries belong to Asia. The improvement in the quality of the assets across countries is also shown by the fact that in 2001 there were around 11 countries whose NPA/Total Loan ratio was above 10 percent, by 2005 this number reduced to 7.

Table 3.2 Bank Non-performing Loans to Total Loans

Countries Australia Bangladesh Brazil Canada 2001 0.6 31.5 5.6 1.5 2002 0.4 28 4.8 1.6 2003 0.3 22.1 4.8 1.2 2004 0.2 17.6 3.8 0.7 2005 0.2 15.3 4.4 0.5

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Chile China Egypt France Germany Hong Kong India Indonesia Japan Korea Malaysia Mexico Pakistan Philippines Russia Singapore Sri Lanka Switzerland Thailand Turkey United Kingdom United States

1.6 29.8 16.9 5 4.6 6.5 11.4 31.9 8.4 3.4 17.8 5.1 23.4 27.7 6.2 8 15.3 2.3 11.5 29.3 2.6 1.3

1.8 25.6 20.2 5 5 5 10.4 24 7.2 2.4 15.8 4.6 21.8 26.5 5.6 7.7 15.3 1.9 16.5 17.6 2.6 1.4

1.6 20.1 24.2 4.8 5.3 3.9 8.8 19.4 5.2 2.6 13.9 3.2 17 26.1 5 6.7 13.7 1.4 13.5 11.5 2.5 1.1

1.2 15.6 16.3 4.2 5.1 2.3 7.2 14.2 2.9 1.9 11.8 2.5 11.6 24.7 3.8 5 9.1 0.9 11.8 6 1.9 0.8

0.9 10.5 25 3.5 4.8 1.5 5.2 15.6 1.8 1.2 9.9 1.8 10.6 20 3.2 3.8 9.6 0.5 11.1 4.8 1 0.7

Source: Global Financial Stability Report, May 2006, IMF While comparing the NPA levels of different countries with each other one should remember that the features relating to the NPA reporting/evaluation practices are not uniform across countries. In some countries the NPA level may be low because their losses are written off at an early stage. In some of the developing countries of Asia Pacific Countries belonging to Economic co-operation (APEC) forum, a loan is classified as non-performing only after it has been in arrears for at least six months; whereas, in India, currently an asset is considered NPA if it is due for 90 days. Also in India due to the lengthy legal process, it takes considerably long time to recover the loan. And, due to many safeguards/procedures, even after a NPA is written off banks continue to hold them in their books, many a time along with the provision made for those loans. Even the classification of NPA into Gross NPA and Net NPA is not uniform because, in some countries the provisions made are general provisions whereas, in India NPAs are considered GNPA for some time even after making provisions. Thus while comparing the NPA level of India with other countries one should remember that in many respect, asset 247

classification norms in India are considerably tighter than the international best practices. The classification standards adopted in a few countries are given in the Appendix (Table A3.7). In addition, countries also do differ in various other respects. In that sense a strict comparison across countries cannot be arrived at. Nonetheless the global picture do reflect a comprehensive view of NPAs across the world.

3.3 NPA norms and Non Performing Assets in India Though the issue of NPA was given more importance after the Narasimham committee report (1991) highlighted its impact on the financial health of the commercial banks and subsequently various asset classification norms were introduced, the concept of classifying bank assets based on its quality began during 1985-86 itself. A critical analysis for a comprehensive and uniform credit monitoring was introduced in 1985-86 by the RBI by way of the Health Code System in banks which, inter alia, provided information regarding the health of individual advances, the quality of credit portfolio and the extent of advances causing concern in relation to total advances. It was considered that such information would be of immense use to bank managements for control purposes. Reserve Bank of India advised all commercial banks (excluding foreign banks, most of which had similar coding system in their organisations) on November 7, 1985, to introduce the Health Code classification system indicating the quality (or health) of individual advances in the following eight categories, with a health code assigned to each borrowal account: 1. Satisfactory - conduct is satisfactory; all terms and conditions are complied with; all accounts are in order; and safety of the advance is not in doubt. 2. Irregular- the safety of the advance is not suspected, though there may be occasional irregularities which may be considered as a short term phenomenon. 3. Sick, viable - advances to units which are sick but viable - under nursing and units in respect of which nursing/revival programmes are taken up.

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4. Sick: nonviable/sticky - the irregularities continue to persist and there are no immediate prospects of regularisation; the accounts could throw up some of the usual signs of incipient sickness 5. Advances recalled - accounts where the repayment is highly doubtful and nursing is not considered worth-while; includes where decision has been taken to recall the advance 6. Suit filed accounts - accounts where legal action or recovery proceedings have been initiated 7. Decreed debts - where decrees (verdict) have been obtained. 8. Bad and Doubtful debts - where the recoverability of the bank's dues has become doubtful on account of short-fall in value of security; difficulty in enforcing and realising the securities; or inability/unwillingness of the borrowers to repay the bank's dues partly or wholly Under the above Health Code System RBI was classifying problem loans of each bank in three categories i.e. i) advances classified as Bad & Doubtful by the bank (corresponding to Health Code No.8) (ii) advances where suits were filed/decrees obtained (corresponding to Health Codes Nos.6 and 7) and (iii) those advances with major undesirable features (broadly corresponding to Health Codes Nos.4 and 5). The Narasimham Committee (1991) felt that the classification of assets according to the health codes is not in accordance with the international standards. It believed that a policy of income recognition should be objective and based on record of recovery rather than on any subjective considerations. Also, before the capital adequacy norms are complied with by Indian banks, it is necessary to have their assets revalued on a more realistic basis on the basis of their realizable value. Thus the Narasimham committee (1991) believed that a proper system of income recognition and provisioning is fundamental to the preservation of the strength and stability of the banking system. The international practice is that an asset is treated as non-performing when interest is due for at least two quarters. In respect of such non-performing assets interest is not recognized on accrual basis but is booked as income only when it is actually received. The committee suggested that a similar practice should be followed by banks

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and financial institutions in India and accordingly recommended that interest on nonperforming assets should be booked as income on accrual basis. The non-performing assets would be defined as an advance where, as on the balance sheet date: 4. In respect of overdraft and cash credits, accounts remain out of order for a period of more than 180 days, 5. In respect of bills purchased and discounted, the bill remains overdue20 and unpaid for a period of more than 180 days, 6. In respect of other accounts, any account to be received remains past due for a period of more than 180 days. As mentioned earlier, the grace period was reduced, and from March 1995 onwards the assets for which the interest has remained unpaid for 90 days should be considered as NPAs. Provisions need to be made for the NPAs and total NPA (gross) minus the provisions is defined as net NPA. Along with providing the detailed definition of the Non-performing Asset, the Narasimham committee (1991) also suggested that for the purpose of provisioning, banks and financial institutions should classify their assets by compressing the health codes into the four broad groups; (i) Standard (ii) Sub-standard, (iii) Doubtful and (iv) Loss. Broadly stated, sub-standard assets would be those which exhibit problems and would include assets classified as non-performing for a period not exceeding two years. Doubtful assets are those non-performing assets which remain as such for a period exceeding two years and would also include loans in respect of which installments are overdue for a period exceeding two years. Loss assets are accounts where loss has been identified but amounts have not been written off.

20

An amount is considered overdue when it remains outstanding 30 days beyond the due date.

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One of the related and important aspects of NPAs is the provisioning. According to the international norms, commercial banks need to keep aside a portion of their income as provision for the bad loans. The amount of provision depends on the type of the NPAs and also the time duration. The Narasimham committee (1991) believed that in the Indian context, given the delays in the legal system, there is bound to be a time lag between an account becoming doubtful of recovery, its recognition as such, and the realization of the security. This factor has to be kept in mind in making provisions, besides market value of the security charged to the banks and institutions. The committee, therefore, recommends that the basis of provisioning against bad and doubtful debts should be as under: 1. In respect of loss assets either the entire assets should be written off in the books or if the asset is permitted to remain in the books for certain reasons, 100 percent of the outstanding should be provided for. 2. In respect of doubtful debts, it should be necessary for the banks to provide 100 percent of the security shortfall, that is, the full extent to which the loans and advances are not covered by the realizable value of the security. Over and above this, it will be necessary for banks and institutions to make a further specific provision to the extent of a certain percentage of even the secured portion. This percentage could vary from 20 to 50 percent depending on the period for which an asset remains in the doubtful category. 3. In respect of sub-standard assets, a general provision of 10 percent of the total outstanding should be created.

3.4 Recovery Mechanism of NPA It was felt by the Government of India that the usual recovery measures like issue of notices for enforcement of securities and recovery of dues is a time consuming process. Thus, in order to speed up the process of recovery of NPAs, the Government of

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India constituted a committee under the chairmanship of late Shri Tiwari in 1981. The committee examined the ways and means of recovering NPAs and recommended, inter alia, the setting up of Special Tribunals which could expedite the recovery process. Later the Narasimham Committee (1991) endorsed this recommendation, and also, suggested setting up of Asset Reconstruction Fund (ARF). The Government of India, if necessary should establish this fund by special legislation, which would take over NPAs from banks and financial institutions, at a discount, and follow up on the recovery of the dues owed to them from the primary borrowers. Based on the recommendations of the Tiwari committee and also of the Narasimham Committee, various Debt Recovery Tribunals were established at various parts of the country. An Asset Reconstruction Company was also established. At present, various measures taken to reduce NPAs include reschedulement, restructuring at the bank level, corporate debt restructuring, and recovery through Lok Adalats, Civil Courts, and Debt Recovery Tribunals and Compromise Settlements. Some of these measures are discussed briefly here.

3.4.1 Debt Recovery Tribunals It was felt by the Tiwari committee (1981) that the civil courts are burdened with diverse types of cases. Recovery of dues due to banks and financial institutions is not given priority by the civil courts. The banks and financial institutions like any other litigants have to go through a process of pursuing the cases for recovery through civil courts for unduly long periods. By 30th Sept 1990, more than 15 lakh cases filed by the public sector banks and about 304 cases filed by the financial institutions were pending in various courts. Recovery of debts involved more than Rs 5622 crores in dues of public sector banks and about Rs 391 crores in dues of the financial institutions. Thus this committee recommended for establishment of Debt Recovery Tribunals (DRTs) which was later endorsed by the Narasimham Committee. Subsequently, the Recovery of Debts Due to Banks and Financial Institutions Act, 1993 was passed which enabled the establishment of DRTs. The DRT Act seeks to provide expeditious adjudication and speedy recovery of dues to banks and financial institutions. Presently, there are 29 DRTs and 5 DRATs functioning all over the country. The pecuniary jurisdiction of these

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Tribunals is Rs.10 lakhs and above. Debts Recovery Tribunals also have jurisdiction over appeals against any of measures taken by the secured creditor or by the authorized officer. In order to make the process faster and to correct the legal irregularity, the Government of India passed an amendment to the DRT Act in 2000. The new statute gives more power to the DRTs in terms of attaching the property of the defaulter and also distribute the sale proceedings of the defaulters property among secured creditors.

3.4.2 Asset Reconstruction Company (India) Limited After recognizing the problems of NPAs, various measures were taken to reduce the NPA levels in the future. However, by then, commercial banks and other financial institutions had already accumulated enough NPAs. It was necessary to free commercial banks and other financial institutions from the problems of recovering NPAs so that they can concentrate on the regular banking business. In this regard, in addition to DRTs, Government of India also decided to set up an agency which can acquire NPAs from commercial banks and recover them. This was also suggested by the Narasimham Committee report where they mentioned about setting up of an Asset Reconstruction Fund. ARCIL is established under the SARFAESI Act 2002 and is registered with Reserve Banks of India and commenced business from 2003. The RBI has so far issued Certificate of Registration to four Securitasation Companies/Reconstruction Companies (SCs/RCs), of which three have commenced their operations. Assets Reconstruction Company (India) Limited (ARCIL) set up in 2003 has provided a major boost to the efforts to recover the NPAs of the banks. During 2005-06, ARCIL acquired 559 cases of NPAs amounting to Rs 21,126 crores. The portfolio of assets acquired by ARCIL was diversified across major industry segments, which were generally performing well in the stock market. About 78 per cent of assets under management were fully/partially operational. There are certain important legal reforms as well to expedite the process of loan recovery and SARFAESI act is a significant step in this direction.

3.4.3 SARFAESI Act

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The legal mechanism for recovery of default loans by usual procedure was too cumbersome and time consuming. Thus it was felt that banks and financial institutions should be given power to take over securities and sell in order to recover the dues. In this regard the Government of India appointed a committee under the chairmanship of Shri T R Andhyarujina, senior Supreme Court advocates and former Solicitor General of India in the year 1999 to look into these matters. The Committee submitted four reports. One among them is related to securitization. Based on the recommendations of the Andhyarujina committee The Securitisation And Reconstruction of Financial Assets And Enforcement of Security Interest (SARFAESI) Act, 2002, was enacted on 17th December 2002. The act provides enforcement of security interest without taking recourse to civil courts. This act was passed with the aim of enabling banks and financial institutions to realise long-term assets, manage problem of liquidity, reduce asset liability mismatches and improve recovery by exercising powers to take possession of securities, sell them and reduce non-performing assets by adopting measures for recovery or reconstruction. The ordinance also allows banks and financial institutions to utilise the services of ARCs/SCs for speedily recovering dues from defaulters and to reduce their non-performing assets. The ordinance contains provisions that would make it possible for ARCs/SCs to directly take possession of the secured assets and/or the management of the defaulting borrower companies without having to resort to time consuming process of litigation and without allowing borrowers to take shelter under provisions of SICA/BIFR. In addition to passing SARFAESI Act certain other legal reforms have also been introduced to speed up the loan recovery process.

3.4.4 Other Legal Reforms One of the important factors responsible for continuing high level of NPAs in the Indian banking industry is the weak legal system. According to an international rating agency called FITCHIBCA The Indian legal system is sympathetic towards the borrowers and works against the banks' interest. Despite most of their loans being backed by security, banks are unable to enforce their claims on the collateral, when the loans turn non-performing, and therefore, loan recoveries have been insignificant.

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However efforts have been made to rectify these problems in terms of judicial process as well as laws. In 1999 a standing committee under the aegis of Industrial Development Bank of India (IDBI) was constituted to have a coordinated approach in the recovery of large NPA accounts, as also for institutionalising an arrangement for a systematic exchange of information in respect of large borrowers (including defaulters and NPAs) common to banks and financial institutions. And, as mentioned above, in 2002 Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act (SARFAESI Act) was passed which empowers the creditors to foreclose non-performing loans and the underlying collateral without going through a lengthy court or tribunal process (Basu, 2005). All these efforts have improved the recovery of NPAs by commercial banks which has in turn helped in reducing the NPA level. The total NPAs recovered through various channel was around Rs 4039 crores during 2003-04 which has increased by many fold to Rs 20578 crores during 2004-05.

3.4.5 Recovery of NPA Using the new institutions and legal options banks and financial institutions have accelerated their recovery of NPAs. The NPAs recovered by scheduled commercial banks through various channels is presented in table 3.3. Between 2003-04 and 2005-06, the total cases referred to various institutions are 932377 which related to the total amount of around Rs 70226 crores out of which around Rs 19075 crore was recovered. In terms of the number of cases, highest number of cases (553042) were referred to Lok Adalats and lowest cases (15812) were referred to DRTs. Whereas, in terms of the amount involved DRTs deal with the highest amount of around Rs 32745 crores and Lok Adalats deal with lowest amount of around Rs 2965 crores. In terms of the recovery, one-time settlement/compromise schemes seems to be doing better as around 58 percent of the amount involved was recovered. DRTs recovered around 29 percent and Lok Adalats recovered around 16 percent of the amount involved. And, around 22 percent of the amount involved was recovered under SARFAESI act. Table 3.3

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NPAs Recovered by SCBs Through Various Channels

One-time settlement/ compromise Scheme 2003-04 No of cases referred Amount involved Amount recovered 2004-05 No of cases referred Amount involved Amount recovered 2005-06 No of cases referred Amount involved Amount recovered 139562 1510 617 132781 1332 880 10262 772 608 Lok Adalats DRTs SARFAESI Act

186100 1063 149 185395 801 113 181547 1101 223

7544 12305 2117 4744 14317 2688 3524 6123 4710

2661 7847 1156 39288 13224 2391 38969 9831 3423

Source: RBI Thus we observe that considerable attention has been paid to the NPA issue and various regulatory as well as institutional mechanisms are put in place. How effective are these changes? This calls for a closer look at the NPA trends in the recent past.

3.5

Non Performing Assets in India

While efforts are on for NPA classifications, refinement of accounting system and measures to reduce NPA in the decade of 1990s , proper practice of these norms took time. Systematic data on NPAs started to become available in a usable form from 1998 only. Though the total GNPA has increased significantly between 1998 and 2002, it has started to decline after that (Table 3.4, Table A3.121). During 1998 the total Gross NPA and Net NPA of the total banking sector was Rs. 34428 crore (around 14.4 percent of gross advance) and Rs. 16098 crores (around 7 per cent of net advance) respectively. During 2005, the GNPA increased even in real terms to Rs 38558 crores (around 5.2 percent of gross advance) whereas, NNPA has reduced to 14181 crores (around 2 percent

21

Nominal Figures are shown in the Appendix (see Table A3.1- A3.6)

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of net advance). The growth rate of GNPA was about 11 percent in 1999 to which started to fall drastically and became negative after 2002. Growth rate becoming negative implies that there is a substantial decline in the GNPA level of commercial banks showing some impact of the sensitization and regulatory changes. Similar trend is observed in the case of Net NPA. The decline in the level of NNPA is sharper than the GNPA. This is mainly because of the increasing level of provisions, as shown in the last three rows of Table 3.4.

Table 3.4 Non Performing Assets of Total Banking Sector (Rs Crore, Real Values)
1998 1999 38275 3848 11.18 14.39 6.36 16098 14.71 6.18 18264 2165 13.45 6.73 2.97 239188 7.02 2.95 260180 20993 8.78 541311 619827 78516 2000 38320 45 0.12 12.79 5.49 18991 727 3.98 6.34 2.72 299697 39516 15.19 697384 77558 2001 38828 508 1.33 11.42 4.91 19774 783 4.13 5.82 2.50 340005 40309 13.45 790257 92873 2002 41430 2602 6.70 10.42 4.62 20787 1013 5.12 5.23 2.32 397502 57496 16.91 896895 106638 2003 39012 -2418 -5.84 8.86 4.04 18548 -2240 -10.77 4.21 1.92 440207 42705 10.74 2004 35007 -4006 -10.27 7.19 3.27 13302 -5246 -28.28 2.73 1.24 486686 46479 10.56 2005 38558 3551 10.14 5.27 2.57 14181 879 6.61 1.94 0.95 731323 244637 50.27 34428

Gross NPA
Change Percentage growth Percent to Gross Advance percent to Gross Assets

Net NPA
Change Percentage growth Percent to Gross Advance Percent to Gross Assets

Gross Advance
Change Percentage growth

Gross Assets
Change

966570 1070292 1497479 69675 103722 427187

257

Percentage growth

14.50 18329 20012 1682 9.18

12.51 19329 -683 -3.41

13.32 19054 -275 -1.43

13.49 20643 1589 8.34

7.77 20465 -178 -0.86

10.73 21705 1241 6.06

39.91 24377 2672 12.31

Gross-net
Change Percentage growth

Source: Computed by author using RBI data.

At the bank group level, public sector banks have the highest non-performing assets with an average GNPA (for the period 1998-2005) of around Rs 31,000 crore (about 11.54 percent to gross advances) and average NNPA of about Rs 16,000 crores (around 5.72 percent of net advance) (compare Table 3.5 and 3.6). While higher GNPA from the public sector is expected, as their share in total lending is also much higher in the total banking sector, GNPA to total advance ratios are also higher for them. In this context we observe that the old private banks rank second in terms of percentage of NPAs in total lending (around 9.96 percent of gross advance) and average NNPA of around 6.15 percent of net advance. This is followed by the new private sector banks with an average GNPA to total advance ration of around 5.51 percent (see table 3.5 and 3.6) and average NNPA to total net advance ratio of around 3.36 percent of net advance. Similarly, high absolute level of total NPA is expected of public sector banks as their volume of lending is also much higher. For the same reason foreign banks rank last both in terms of average GNPA as well as NNPA. But when we compare the public sector banks against private banks in terms of percentage of total lending (Table 3.6) we observe that public sector banks are as good as or as bad as their private counterparts. In some years public sector banks are indeed doing better that the private sector banks. But when compared with the foreign banks they do not fare well. This may be partly because foreign banks are long accustomed to the NPA norms in their parent country. Further, various credit related welfare programs are carried out through public sector banks. They also have maximum reach in the rural areas. Whether having maximum rural branches is indeed creating bad loans is a matter that needs closer scrutiny and will be examined formally in Chapter 4. One feature however is worth noting here. Growth rate of gross NPAs of the private sector banks are higher than the public sector banks while growth of advances of public 258

sector banks are at par with the private banks. It thus appears that after reform public sector banks are able to tackle the NPA problem more effectively than the private banks (Table 3.6). However, one important observation from the table 3.6 is that, GNPA as percent of gross advance as well as NNPA as percent of net advance has been declining over time across all bank groups22. Table 3.5 Per Cent Growth Rates of Gross and Net NPAs of Scheduled Commercial Banks (Real values)
1998 Public Sector Banks Gross NPAs 30930 Growth Rate Net NPAs 14385 Growth Rate Old Private Banks Gross NPAs 1893 Growth Rate Net NPAs 1065 Growth Rate New Private Banks Gross NPAs 266 Growth Rate Net NPAs 197 Growth Rate Foreign Banks Gross NPAs 1339 Growth Rate Net NPAs 451 Growth Rate 1999 33705 8.97 15781 9.70 2466 30.30 1520 42.72 568 113.76 398.25 102.00 1536 14.76 564 25.10 2000 33567 -0.41 16494 4.52 2511 1.79 1565 2.93 596 4.95 400.58 0.58 1647 7.21 532 -5.82 2001 33304 -0.78 17042 3.32 2647 5.45 1688 7.89 985 65.32 565.91 41.27 1892 14.88 478 -10.05 2002 33018 -0.86 16346 -4.09 2836 7.13 1762 4.36 3982 304.28 2141.64 278.44 1594 -15.76 538 12.49 2003 30708 -7.00 14118 -13.63 2583 -8.92 1556 -11.70 4106 3.10 2351.52 9.80 1615 1.34 523 -2.79 2004 27848 -9.31 10191 -27.82 2373 -8.13 1156 -25.67 3222 -21.52 1468.10 -37.57 1564 -3.18 486 -6.99 2005 31300 12.39 11007 8.01 2782 17.22 1229 6.33 3026 -6.07 1515.87 3.25 1450 -7.29 429 -11.87

Table 3.6
Percentage Growth Rates of Gross NPA and Gross Advance
1999 Public Sector Banks
22

2000

2001

2002

2003

2004

2005

For nominal figures see table A3.2 and A3.3 in the Appendix. For frequency distribution of NPAs under different classifications see Table A3.6 in the Appendix.

259

Growth of Gross Advance Growth of Gross NPA Old Private Banks Growth of Gross Advance Growth of Gross NPA New Private Banks Growth of Gross Advance Growth of Gross NPA Foreign Banks Growth of Gross Advance Growth of Gross NPA

13.98 13.27 12.69 35.43

17.05 15.82 3.06 2.59 22.12 13.03 5.34 9.03

15.39 3.29 10.61 11.62

13.10 -4.22 15.93 -6.20

14.83 -4.72 13.04 -3.47

25.66 -8.17 21.30 -4.23

25.43 60.33 40.77 141.37 24.34 25.33 6.58 122.19 8.61 70.93 321.21 6.18 -17.55 -23.26 0.45 19.28 20.46 22.27 10.95 18.78 10.52 -12.23 6.33 4.37 17.20 1.72 24.43 -24.26

Source: Computed by author using RBI data. Going to the disaggregated level of NPAs it has been observed that amongst the bad loans, maximum is substandard loan and proportion of loss assets is rather low (Table 3.7). At the total banking sector level, on an average (for the period 1998-2005) around 89 percent of the total loan assets fall under the standard asset category. When we consider the rest, 3.3 percent under sub-standard assets, around 3 percent under doubtful assets and around 1.3 under loss assets. And, the total NPA is around 10.6 percent of the total loan asset. Thus, loss assets, even for the public sector banks are rather low. Looking at the temporal behaviour of the share of various types of assets, on average, as the share of standard asset is improving over time, naturally, the shares of sub-standard assets, doubtful assets, loss assets and NPAs in the total loan asset are declining. This essentially implies that the quality of the loan asset of Indian commercial banks is improving. What is clear from Table 3.6 about low levels of NPAs of the foreign banks is also seen from Table 3.7. From a disaggregated analysis at the bank-group level it appears that the quality of the loan assets of foreign banks is better than the quality of the loan asset of other bank groups. While the share of the standard asset in the total loan asset of foreign banks is 94 percent, it is 88.5 and 91 percent in the case of public sector and Indian private banks. On the other hand while the share of NPA in the total loan asset of foreign banks is 5.8 percent, it is 11.5 and 8.7 percent in the case of public sector banks and Indian private banks. However, proportion of loss assets of public sector banks and foreign banks are quite comparable and they are comparatively lower for the private banks.

260

Table 3.7
Bank group-wise Classification of Loan Assets of Scheduled Commercial Banks (Rs Crores) 1998 1999 2000 2001 2002 2003 2004 2005 Public Sector Banks Standard Assets 239318 273618 326783 387360 452862 523724 610435 824253 Per cent to total 84.0 84.1 86.0 87.6 88.9 90.6 92.2 94.6 Substandard Assets 14463 16033 16361 14745 15788 14909 16909 10838 Percent to Total 5.1 4.9 4.3 3.3 3.1 2.6 2.6 1.2 Doubtful assets 25819 29252 30535 33485 33658 32340 28756 29988 Per cent to total 9.1 9 8 7.6 6.6 5.6 4.3 3.4 Loss Assets 5371 6425 6398 5644 7061 6840 5876 5771 Per cent to total 1.9 2 1.7 1.5 1.4 1.2 0.9 0.7 Total NPAs 45653 51710 53294 54774 56507 54089 51541 46597 Per cent to total 16 15.9 14 12.4 11.1 9.4 7.8 5.4 Indian Private Banks Standard Assets 33567 38394 53317 65071 109216 131620 167076 216448 Per cent to total 91.3 89.2 91.5 91.5 90.3 90.8 94.2 96.1 Substandard Assets 1766 2657 2137 2585 4738 3703 3127 2213 Percent to Total 4.8 6.2 3.7 3.6 3.9 2.6 1.8 1 Doubtful assets 1077 1591 2355 3069 6539 8512 6391 5578 Per cent to total 2.9 3.7 4 4.3 5.4 5.9 3.6 2.5 Loss Assets 343 407 439 424 390 1118 825 900 Per cent to total 0.9 0.9 0.8 0.6 0.3 0.8 0.5 0.4 Total NPAs 3186 4655 4931 6078 11667 13333 10343 8691 Per cent to total 8.7 10.8 8.5 8.5 9.7 9.2 5.8 3.9 Foreign Banks Standard Assets 28996 28702 34817 42285 47838 50851 59619 72963 Per cent to total 93.6 92.4 93 93.1 94.5 94.6 95.2 97 Substandard Assets 1198 1238 1096 876 856 994 990 714 Percent to Total 3.9 4 2.9 1.9 1.7 1.8 1.6 0.9 Doubtful assets 250 507 798 1202 1004 944 1099 974 Per cent to total 0.8 1.6 2.1 2.6 2 1.8 1.8 1.3 Loss Assets 528 612 721 1033 920 954 924 569 Per cent to total 1.7 2 1.9 2.3 1.8 1.8 1.5 0.8 Total NPAs 1976 2357 2615 3111 2780 2892 3013 2257 Per cent to total 6.4 7.6 7 6.9 5.5 5.4 4.8 3

Source: Report on Trends and Progress of Banks in India, various issues The above statistics shows the NPA problem at the aggregate level. In order to tackle the problem a disaggregated analysis is necessary to examine what type of loans lead to more NPAs. This necessitates an anlysis of sector-wise NPAs.

3. 6 Sector-wise NPA: NPA arising from the SSI sector

261

One of the important issue raised in the case of the NPAs of Indian commercial banks is that the directed credit policy followed by the RBI under social banking motto of the Government led to increase in the level of NPAs. To examine this we first look at the share of NPAs from the priority sector vis--vis non priority sector loans. Table 3.8 reveals that the share of the NPA of non-priority sector is indeed higher than the share of the NPA of priority sector and this trend is continuing over the years. Table 3.8
Sector Wise Non Performing Assets of Indian Scheduled Commercial Banks (Rs Crore, Real Values) Priority Public Non priority Sector Sector Item Agriculture Small scale Others Sector Bank Group: State Bank and Associates Amount 1839 2317 1283 5439 739 6118 Per cent to total 15.0 18.8 10.4 44.2 6.0 49.7 Amount 1849 2113 1278 5273 362 5908 Per cent to total 16.0 18.3 11.1 45.7 3.1 51.2 Amount 1688 1740 1144 4572 299 4757 Per cent to total 17.3 17.8 11.7 46.7 3.1 48.6 Amount 1351 1232 1272 3856 119 4216 Per cent to total 16.5 15.0 15.5 47.1 1.5 51.5 Amount 1504 1175 1926 4641 111 5042 Per cent to total 15.4 12.0 19.7 47.4 1.1 51.5 Nationalised Banks Amount 2654 3982 2640 9276 303 10512 Per cent to total 14.8 22.2 14.7 51.7 1.7 58.6 Amount 2724 4042 2659 9425 290 11779 Per cent to total 12.7 18.8 12.4 43.9 1.4 54.8 Amount 2688 4029 2870 9586 897 11726 Per cent to total 12.0 17.9 12.8 42.7 4.0 52.2 Amount 2561 3871 2922 9026 2379 9669 Per cent to total 13.8 20.8 15.7 48.6 12.8 52.0 Amount 3294 3972 3569 10834 274 10120 Per cent to total 15.6 18.8 16.9 51.3 1.3 47.9 Private Banks Amount 194 599 308 1101 75 2676 Per cent to total 5.0 15.6 8.0 28.6 2.0 69.4 Amount 257 868 364 1489 18 5314 Per cent to total 3.8 12.7 5.3 21.8 0.3 77.9 Amount 305 716 364 1385 54 5135 Per cent to total 4.5 10.7 5.4 20.6 0.8 76.4 Amount 248 681 408 1338 40 4204 Per cent to total 4.4 12.2 7.3 24.0 0.7 75.3

Year 2001 2002 2003 2004 2005

2001 2002 2003 2004 2005

2001 2002 2003 2004

262

2005 Amount Per cent to total

307 5.3

638 11.0

497 8.6

1442 24.9

28 0.5

4331 74.7

Source: Computed by author using RBI data

As can be seen from the table, the average share the NPA of non-priority sector in the total NPA is around 50.5%, 53.4% and 74.7% for SB&A, NP and PB respectively, whereas, the average share of NPA of priority sector in the total NPA is around 46.2%, 47.9% and 23.9% for SB&A, NB and PB respectively. One important observation is that the share of priority sector NPA is less in the case of Private Banks compared to other bank groups. In the case of sub-category of priority sector, the share of agriculture sector NPA in the total NPA is only around 4.61 percent for Private Banks whereas it is around 16 percent for SB&A and 13 percent for NB. While it has been often highlighted in the literature that NPA arising from the priority sector is less than that of non priority sector related NPAs , a point often missed is that priority sector constitute about 40% of total lending. Therefore, it is important to examine NPA figures in proportion to the advances made on that particular sector. Computation of sector-wise NPAs indeed reveals that NPA arising from SSI sector is much higher that the other sectors. While NPAs from agriculture sector was about 12.4% in 2002 (Table 3.9), it was as high as 21.16% for the SSI sector in the same year. This percentage however declined to 6% for the agriculture sector and to 11% for the SSI sector. Thus declining trend is prominent uniformly across all sectors (table 3.923). Table 3.9 Sector wise NPA of Commercial Banks (Real Values, Rs Crore)
Agriculture NPA % to credit to agriculture SSI NPA % to credit to SSI Other Priority Sector NPA
23

2002 2003 Public Sector Banks 4573.01 4375.66 12.40 10.93 6155.43 5768.80 21.16 19.30 3937.08 4013.53

2004 3912.20 8.57 5102.91 16.20 4194.17

2005 4796.06 6.64 5144.44 11.48 5493.14

Nominal figures are presented in table A3.4 in the Appendix.

263

% to credit to other priority sector 12.54 Total Priority Sector NPA 14698.18 % to credit to total priority sector credit 14.69 Non-Priority Sector NPA 18339.32 % to credit to non-priority sector credit 9.28 Private Banks Agriculture NPA 256.76 % to credit to agriculture 5.47 SSI NPA 868.39 % to credit to SSI 17.24 Other Priority Sector NPA 363.62 % to credit other priority sector 6.85 Total Priority Sector NPA 1488.76 % to credit to total priority sector credit 9.90 Non-Priority Sector NPA 5332.73 % to credit to non-priority sector credit 9.58

9.93 14158.16 12.48 18093.85 8.43 304.74 4.52 716.39 18.40 363.84 3.64 1384.97 6.65 5334.00 8.59

8.07 12881.84 9.75 13891.00 6.16 248.02 3.12 680.87 16.60 408.27 2.93 1338.41 5.06 4244.56 6.11

6.64 15469.35 7.62 15454.60 4.10 306.80 2.14 637.55 11.22 497.16 1.94 1441.52 3.12 4357.16 5.15

Source: Computed by author using RBI data. However, looking at the growth rate of NPAs across sectors we observe a negative trend for the SSI sector. On the other hand for agriculture and priority sector figures concerning the year 2005 shows some increment (Table 3.1024).

Table 3.9
Per Cent Growth Rates of Sector Wise Gross Non Performing Assets (Real Value)
Year Agriculture 2002 2003 2004 2005 2002 2003 2004 2005 0.52 -8.69 -19.96 11.32 2.63 -1.34 -4.71 28.60 Small scale Priority Others Sector Public Non -priority Sector Sector -50.98 -17.57 -60.16 -6.71 -4.34 208.88 165.37 -88.50 -3.43 -19.48 -11.37 19.59 12.04 -0.45 -17.54 4.66

State Bank and Associates

-8.79 -0.34 -3.05 -17.66 -10.53 -13.30 -29.18 11.23 -15.67 -4.68 51.42 20.36 Nationalised Banks 1.53 0.70 1.61 -0.33 7.94 1.71 -3.93 1.82 -5.84 2.61 22.13 20.02 Private Banks

24

Nominal figures are presented in Table A3.5 in the Appendix.

264

2002 2003 2004 2005

32.18 18.69 -18.61 23.74

44.93 -17.50 -4.96 -6.33

18.17 0.06 12.21 21.81

35.20 -6.97 -3.36 7.74

-75.74 194.33 -24.89 -30.51

98.57 -3.38 -18.12 3.01

Source: Computed by author using RBI data. Thus though SSI sector currently has a higher NPA to total advance ratio there is an improvement in recovery rates and NPA from this sector shows a declining trend even in real terms.

3.7 Conclusion
The problem of NPA has received considerable attention after financial sector liberalization in India. Accounting norms have been modified substantially and mechanisms are put in place for reduction of bad loans. Our survey of banks however shows that (see chapter 7) mainly due to the awareness of the problem of bad loans at the bank level, NPAs have indeed come down considerably. It remains true that NPA arising from the priority sector lending is still higher than the non priority sector. Within priority sector SSIs performance is worse than the others. Given this observation a need has been felt to study this problem in some detail. In the next section therefore, we look at the determinants of NPA for the Indian banking sector in general and for the SSI sector in particular. Appendix to Chapter 3 Table A3.1 Non Performing Assets of Total Banking Sector: Nominal Values (Rs Crore)
Gross NPA Change Percentage growth Gross Advance Change Percentage growth 1998 50815 1999 58722 7907 15.56 399167 46128 13.07 2000 60841 2119 3.61 475827 76660 19.20 2001 63741 2900 4.77 558157 82330 17.30 2002 70861 7120 11.17 679875 121718 21.81 2003 68717 -2144 -3.03 775386 95511 14.05 2004 64787 -3930 -5.72 900706 125320 16.16 2005 58299 -6488 -10.01 1105760 205054 22.77

353039

265

Gross Assets Change Percentage growth Net NPAs Change Percentage growth Gross-net Change Percentage growth

798970

23761

27054

950934 151964 19.02 28020 4259 17.92 30702 3648 13.48

1107234 156300 16.44 30152 2132 7.61 30689 -13 -0.04

1297296 190062 17.17 32462 2310 7.66 31279 590 1.92

1534023 236727 18.25 35554 3092 9.52 35307 4028 12.88

1702529 168506 10.98 32670 -2884 -8.11 36047 740 2.10

1980782 278254 16.34 24617 -8053 -24.65 40170 4123 11.44

2264188 283405 14.31 21441 -3176 -12.90 36858 -3312 -8.24

Source: RBI Table A3.2

Per Cent Growth Rates of Gross and Net NPAs of Scheduled Commercial Banks (Nominal Terms) 1998 1999 2000 2001 2002 2003 2004 2005 Public Sector Banks Gross NPAs 45653 51710 53294 54672 56473 54090 51538 47325 Growth Rate 13.27 3.06 2.59 3.29 -4.22 -4.72 -8.17 Net NPAs 21232 24211 26188 27977 27958 24867 18860 16642 Growth Rate 14.03 8.17 6.83 -0.07 -11.06 -24.16 -11.76 Old Private Banks Gross NPAs 2794 3784 3986 4346 4851 4550 4392 4206 Growth Rate 35.43 5.34 9.03 11.62 -6.20 -3.47 -4.23 Net NPAs 1572 2332 2484 2771 3013 2740 2140 1859 Growth Rate 48.35 6.52 11.55 8.73 -9.06 -21.90 -13.13 New Private Banks Gross NPAs 392 871 946 1617 6811 7232 5963 4576 Growth Rate 122.19 8.61 70.93 321.21 6.18 -17.55 -23.26 Net NPAs 291 611 636 929 3663 4142 2717 2292 Growth Rate 109.97 4.09 46.07 294.29 13.08 -34.40 -15.64 Foreign Banks Gross NPAs 1976 2357 2615 3106 2726 2845 2894 2192 Growth Rate 16.16 9.87 15.81 -13.94 4.18 1.69 -32.03 Net NPAs 666 866 844 785 920 921 900 648 Growth Rate 23.09 -2.61 -7.52 14.67 0.11 -2.33 -38.89

Table A3.3 Gross and Net NPAs of Scheduled Commercial Banks (Nominal Values, Rs Crore)
1998 Public Sector Banks Gross NPAs Percent to Gross Advance Percent to Gross Asset Net NPAs Percent to Net Advance Percent to Net Assets Old Private Banks Gross NPAs 45653 16 7 21232 8.2 3.3 2794 1999 51710 15.9 6.7 24211 8.1 3.1 3784 2000 53294 14 6 26188 7.4 2.9 3986 2001 54672 12.4 5.3 27977 6.7 2.7 4346 2002 56473 11.1 4.9 27958 5.8 2.4 4851 2003 54090 9.4 4.2 24867 4.5 1.9 4550 2004 51538 7.8 3.5 18860 3 1.3 4392 2005 47325 5.7 2.8 16642 2.1 1.0 4206

266

Percent to Gross Advance Percent to Gross Asset Net NPAs Percent to Net Advance Percent to Net Assets New Private Banks Gross NPAs Percent to Gross Advance Percent to Gross Asset Net NPAs Percent to Net Advance Percent to Net Assets Foreign Banks Gross NPAs Percent to Gross Advance Percent to Gross Asset Net NPAs Percent to Net Advance Percent to Net Assets

10.9 5.1 1572 6.5 2.9 392 3.5 1.5 291 2.6 1.1 1976 6.4 3.0 666 2.2 1.0

13.1 5.8 2332 9.0 3.6 871 6.2 2.3 611 4.5 1.6 2357 7.6 3.1 866 2.9 1.1

11.3 5.1 2484 7.3 3.2 946 4.2 1.6 636 2.9 1.1 2615 7.0 3.2 844 2.4 1.0

10.9 5.1 2771 7.3 3.3 1617 5.1 2.1 929 3.1 1.2 3106 6.8 3.0 785 1.8 0.8

11.0 5.2 3013 7.1 3.2 6811 8.9 3.9 3663 4.9 2.1 2726 5.4 2.4 920 1.9 0.9

8.9 4.3 2740 5.5 2.6 7232 7.6 3.8 4142 4.6 2.2 2845 5.3 2.4 921 1.8 0.8

7.6 3.6 2140 3.8 1.8 5963 5.0 2.4 2717 2.4 1.1 2894 4.6 2.1 900 1.5 0.7

6.0 3.2 1859 2.7 1.4 4576 3.6 1.6 2292 1.9 0.8 2192 2.8 1.4 648 0.9 0.4

Source: Report on Trends and Progress of Banks in India, RBI, various issues

Table A3.4 Sector Wise Non Performing Assets of Indian Scheduled Commercial Banks (Nominal Values)
Year 2001 2002 2003 2004 2005 Item Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Small Priority Sector Agriculture scale Others Bank Group: State Bank and Associates 3019.44 3803.19 2105.72 8928.35 14.95 18.84 10.43 44.22 3162.26 3614.21 2186.40 9018.74 16.02 18.31 11.07 45.68 2973.52 3064.80 2014.52 8052.84 17.26 17.79 11.69 46.74 2500.59 2280.54 2354.42 7135.55 16.50 15.04 15.53 47.07 2274.19 1776.01 2912.69 7016.89 15.36 11.99 19.67 47.38 Public Sector 1212.75 6.01 619.41 3.14 525.82 3.05 220.09 1.45 167.75 1.13 Non priority Sector 10043.57 49.74 10105.41 51.18 8379.44 48.64 7802.97 51.48 7623.56 51.48 Total 20190.70 19743.57 17228.10 15158.61 14808.32

267

2001 2002 2003 2004 2005

Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total Amount Per cent to total

4357.21 14.79 4659.29 12.67 4733.83 11.96 4739.70 13.78 4979.85 15.58 318.89 5.04 439.16 3.76 536.78 4.54 459.01 4.44 464.04 5.29

2001 2002 2003 2004 2005

Nationalised Banks 6536.22 4334.46 22.18 14.71 6913.86 4547.46 18.81 12.37 7096.43 5054.96 17.93 12.77 7163.38 5407.70 20.83 15.72 6004.95 5395.68 18.79 16.88 Private Banks 983.60 505.15 15.55 7.98 1485.27 621.92 12.73 5.33 1261.86 640.87 10.66 5.42 1260.08 755.58 12.20 7.31 964.30 751.96 10.99 8.57

15227.89 51.68 16120.60 43.85 16885.52 42.66 16704.78 48.57 16380.49 51.25 1807.64 28.61 2546.34 21.82 2439.51 20.61 2476.98 23.97 2180.30 24.86

498.09 1.69 496.44 1.35 1579.14 3.99 4402.97 12.80 413.54 1.29 123.37 1.95 31.18 0.27 94.51 0.80 74.58 0.72 42.34 0.48

17257.44 58.57 20145.74 54.80 20654.24 52.18 17894.77 52.04 15300.80 47.87 4393.46 69.44 9089.47 77.91 9044.07 76.42 7780.76 75.30 6547.87 74.66

29464.42 36762.81 39580.99 34389.70 31964.13

6326.95 11667.29 11834.88 10332.36 8770.50

Source: Report on Trends and Progress of Banks in India, various issues

Table A3.5 Per Cent Growth Rates of Sector Wise Gross Non Performing Assets
Year 2002 2003 2004 2005 2002 2003 2004 2005 2002 2003 2004 2005 Agriculture 4.73 -5.97 -15.90 -9.05 6.93 1.60 0.12 5.07 1306.02 -88.03 -14.49 1.10 Small Priority Scale Sector Industries Others State Bank and Associates -4.97 3.83 1.01 -15.20 -7.86 -10.71 -25.59 16.87 -11.39 -22.12 23.71 -1.66 Other Nationalised Banks 5.78 4.91 5.86 2.64 11.16 4.74 0.94 6.98 -1.07 -16.17 -0.22 -1.94 Private Banks 51.00 -93.55 -89.31 -15.04 3.05 -4.20 -0.14 17.90 1.54 -23.47 -0.48 -11.98 Public Sector -48.93 -15.11 -58.14 -23.78 -0.33 218.09 178.82 -90.61 6426.62 -98.83 -21.09 -43.23 Non priority Sector 0.62 -17.08 -6.88 -2.30 16.74 2.52 -13.36 -14.50 106.89 -0.50 -13.97 -15.85 Total -2.21 -12.74 -12.01 -2.31 24.77 7.67 -13.12 -7.05 84.41 1.44 -12.70 -15.12

268

Table A3.6 : Frequency distribution of NPAs under various classifications

Bank Group Wise Frequency Distribution of NPA for the period 1997-2005 (Average) Bank Group/Percent 0-5 5-10 10-15 15-20 20-25 >25 Gross NPA to Total Asset Ratio SBI&A 41 31 0 0 0 0 NB 94 67 7 3 0 0 PB 176 80 11 0 0 0 FB 191 35 20 10 5 14 Net NPA to Total Asset Ratio SBI&A 71 1 0 0 0 0 NB 163 8 0 0 0 0 PB 244 23 0 0 0 0 FB 237 27 9 2 0 0 Gross NPA to Gross Advance Ratio SBI&A 12 20 27 13 0 0 NB 20 54 46 29 11 11 PB 64 88 71 29 4 11 FB 127 45 24 16 14 49 Net NPA to Net Advance Ratio SBI&A 29 34 9 0 0 0 NB 71 71 22 4 2 1 PB 127 107 22 4 6 1 FB 182 33 23 9 8 20 Gross NPA to Gross Advance Ratio 0-5 5-10 10-15 15-20 20-25 33 17 15 16 4 26 19 21 15 5 17 21 21 18 8 18 23 28 12 3 22 22 26 5 3 21 24 21 9 2 19 28 21 7 0 26 30 12 3 1 41 23 3 2 3 Net NPA to Net Advance Ratio 0-5 5-10 10-15 15-20 44 34 10 2 39 32 17 2 35 32 17 3 38 37 10 4 40 33 7 2 38 31 7 1 50 25 5 1

Year/ Percent 1997 1998 1999 2000 2001 2002 2003 2004 2005

>25 7 7 9 10 8 8 10 7 5

Year / Percent 1997 1998 1999 2000 2001 2002 2003

20-25 2 2 5 2 1 2 1

>25 0 1 2 3 3 6 3

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2004 2005

60 65

12 9

1 2

2 0

1 0

3 1

Frequency Distribution of NPA for the period 1997-2005

0-5 Frequency Percent Frequency Percent Frequency Percent Frequency Percent 5-10 10-15 15-20 20-25 Gross NPA to Total Asset Ratio 502.00 213.00 38.00 13.00 5.00 63.95 27.13 4.84 1.66 0.64 Net NPA to Total Asset Ratio 715.00 59.00 9.00 2.00 0.00 91.08 7.52 1.15 0.25 0.00 Gross NPA to Gross Advance Ratio 223.00 207.00 168.00 87.00 29.00 28.41 26.37 21.40 11.08 3.69 Net NPA to Net Advance Ratio 409.00 245.00 76.00 17.00 16.00 52.10 31.21 9.68 2.17 2.04 >25 14.00 1.78 0.00 0.00 71.00 9.04 22.00 2.80

Table A3.7 Prudential Norms for Asset Classification Adopted by India and Some Other Countries
Country Indonesia Categories Current Sub-standard Doubtful Loans Classification System Installment Credit with no arrears, other credit in arrears less than 90 days, overdrafts less than 15 days. Generally, loans with payments in arrears between three and six months. Non-performing loans that can be rescued and the value of collateral exceeds 75 per cent of the loan, or loans that cannot be rescued, but are fully collateralised. Doubtful loans that have not been serviced for 21 months; credit in process of bankruptcy/liquidation. Provisioning requirements 0.5 per cent 10 per cent 50 per cent

Loss

100 per cent Loans must be written off 21 months after litigation, indicates the loans will not have to be repaid. 0.5 per cent 1 per cent

Korea

Current Special mention

Borrower's credit conditions (including collateral) are good and collectibility of interest and principal are certain. Payments are past due for between three months and six months, but collection is

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Sub-standard

Doubtful Estimated loss

Malaysia Standard Doubtful Bad

Philippines

Unclassified Special mention Sub-standard Doubtful Loss

Argentina Normal Potential risk

certain. Loans covered by collateral but borrower's 20 per cent credit conditions are deteriorating and payments are more than six months past due. Unsecured portion of the loans that are 75 per cent more than six months past due and losses are expected. Unrecoverable amounts due net of 100 per cent collateral. Loans must be written off within six days of being declared unrecoverable; Write-offs in excess of W300 million require Bank of Korea approval. For loans less than RM 1 million More than a normal risk of loss due to 0 per cent adverse factors; past due for between 6 and 12 months. Collection in full is improbable and there is 50 per cent of net (of collateral) high risk of default; past due for between outstanding value 12 and 24 months Uncollectible; past due for more than 24 100 per cent of net outstanding value months. Loans must be written off when bankruptcy hearings have finished and/or partial or full repayment is unlikely. A general provision of at least 1 per cent of total loans net of interest in suspense and specific provisions is also required. Borrower has the apparent ability to satisfy 0 per cent of net (of collateral) obligations in full; no loss in collection is exposure. anticipated. Potentially weak due, for example, to 0 per cent inadequate collateral, credit information, or documentation. Loans that involve a substantial degree of 25 per cent risk of future loss. Loans on which collection or liquidation in 50 per cent full is highly improbable, substantial losses are probable. Uncollectible or worthless. 100 per cent Interest is not accrued on past-due loans, which are loans or other credit not paid at the prescribed maturity date or, in the case of instalment credit, in arrears by more than a prescribed amount depending upon the frequency of instalments. Consumer Loans Commercial Loans Liquid Preferred Without G'tee G'tee G'tee Less than 31 days No doubt exists. 1 per cent 1 per cent 1 per cent overdue 31- 89 days overdue Performing, but 1 per cent 3 per cent 5 per cent

271

sensitive to changes or more than 30 days overdue. Problem 90 - 179 days Problems meeting 1 per cent 12 per cent 25 per cent overdue obligations; or80-179 days overdue High risk 180-365 days over- Highly unlikely to 1 per cent 25 per cent 50 per cent due or subject to meet obligations; or judicial proceedings more than 180 days for default overdue. Irrecoverable More than 365 days Obligations cannot be 1 per cent 50 per cent 100 per cent overdue met; more than365 days overdue Irrecoverable for Bankruptcy/ Bankruptcy/ 100 per cent100 per cent 100 per cent technical decision liquidation/ liquidation/ insolvency insolvency Chile Consumer Mortgage Commercial Minimum initial provision (for NPAs) (allowance A - Current Current Current Probability of default = on consumer loan and mortgage period is 90 B 0% loan(NPAs) is required to be made @ days in all B 1 - 30 days 1- 179 Probability of default 60% and 1% respectively whereas the the3 types of C days > 0%,< 5% provisioning requirement on advances) D 3 - 59 days > 179 days Probability of default commercial loan is subjective = > 5%, < 40% 60-119 days N.A Probability of default = .> 40%, < 80% >120 days N.A. Probability of default = >80%, < 100% Peru A - Normal Current Current Current with no doubts Minimum initial provision @ 30%, (allowance B - Potential 10-29 days 32-89 daysDemonstrated 1% and 15% is required to be made on period is 30, problems deficiencies consumer loan, mortgage loan and 30 and 15 commercial loan (NPAs) respectively. days C - Sub30-59 days 90-119 60-119 days respectively standard days for the three D - Doubtful 60-120 days 120 - 365 120 - 364 days types of days advances) E - Loss > 120 days > 365 days> 365 days India Sub-standard Loans that have been non-performing for up to 10 per cent two years, term loans on which the principal has not been reduced for more than one year, and all rescheduled debts. Doubtful Loans that have been non-performing for two to 100 per cent of unsecured assets; for three years and term loans on which the principal secured assets; 20 per cent if doubtful has not been reduced for more than two years. for less than one year; 30 per cent if doubtful for one to three years, 50 per cent if doubtful for more than three years. Loss All other assets deemed irrecoverable, where the 100 per cent loss has been identified by internal or external auditors or by the Reserve Bank of India inspectors, but where the amount has not been written off.

Source: Global NPL Report

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CAHPTER 4

Determinants of Non Performing Assets

4.1 Introduction Given that the NPA has strong implications on the health of the commercial banks and also the economy, it is essential to contain the NPA levels of the commercial banks. This calls for identification of the factors that can cause an asset to become NPA. A study conducted by the RBI, based on the information related to 33banks shows that the NPA level in banks are generally related to the performance level of the industrial units to which the banks have lent loan (Muniappan, 2002). The factors could be management inefficiency of borrowal units, obsolescence, lack of demand, non- availability of inputs, environmental factors etc. In a few cases default occurs due to the internal factors of banks such as weak appraisal or follow-up of loans. While a micro level study will reveal some of these causes , before going to such analysis it is essential to get a picture of the determinants of NPA at the macro level. In this regard an attempt is made in the current chapter to identify the factors influencing the NPA at the macro level. Given this back ground this present chapter is designed as follows; in the next section a brief review of studies related to NPAs at the international level, as well as in India is presented. Section 3 spells out the methodology used in the study to analyse the determinants of the NPAs. While section 4 will present various sources of data used in the study, section 5 contains the empirical results and the discussion. Finally, concluding remarks are presented in section six.

4.2. Review of Literature Over the last several years the issue of Non-Performing Assets has received considerable attention from the policy makers and researchers all over the world. High level of NPA is affecting not only the developing nations in Asia but even some of the advanced economies like Japan and Germany (see also Chapter 3) are faced with this problem. The question of NPA was given more emphasis after the BASEL committee stressed that non-performing assets, from the financial systems across the globe should be reduced and also prescribed various prudential norms. A number of studies which look at

273

the bank-failures concerning different countries note that the major reason for bank failure is their Non-Performing Assets, since just before the failure they had accumulated large amount of NPLs (Demirguc-Kunt 1989, Whalen 1991, and Barr and Siems 1994). It has been observed that the weak banks, in developed and developing countries alike, do not report their true no-performing loans (NPL) level, due to which the issues become complicated when they are hit by a crisis (Tanaka and Hoggarth, 2006). The problem of Non-Performing Loans is predominant in Asian countries, more specifically in the East Asian countries (see Chapter 3). In fact, the higher levels of NPL were one of the important reasons for the East Asian Financial Crisis of 1997. After the so-called economic bubble burst in Japan in 1990, it went through a decade of economic depression, which, to some extent, is due of the failure of the Japanese government to control its NPLs (Asami, 2000). As discussed in Chapter 3, Japan has the highest NPL levels in the world. In 2004 its NPL was around US$ 330 billion, which accounted to around 25 percent of the world NPL (Global NPL Report 2004). Japanese banks have lost 72 trillions yen due to bad loans since March 1992 until March 2001. The bad loan per total loan ratio has risen from 2 percent in 1992 to 6 percent in 1999 (Hanah, 2005). However, it has been observed that the real problem of Japans NPL lies in understanding the problem of the corporate to which banks are giving loans. Instead of banks continuing to roll over loans to loss making corporate they should divert the funds to profit making corporate (Hubbard, 2002). The only East Asian country, which not only avoided the recent financial crises, but also continued to exhibit strong growth, is China (Huang and Bonin, 2001). However, like many East Asian countries, China also holds high level of Non Performing Loans, which might prove dangerous. In 2003 Chinas NPL was around US$ 307 billion, which accounted for around 23 percent of the global NPA (Global NPL Report 2004). Measured as a percent of the total outstanding loans, the NPL of China ranged from 18 percent to 40 percent Sprayregen et al (2004). Apart from the problem of high NPLs, Chinese banking industry suffers from low capital base also. The public sector dominance of the Chinese banking industry, along with the policy of policy lending led to the Public Sector Enterprise (Chinese banks are expected to lend around 30-40 percent of their total loans to PSE), increased NPLs of the Chinese banking industry (Huang and Bonin, 2001).

274

Recognizing the extent of damage NPLs can cause on economic performance, considerable efforts have gone in understanding the factors that effect NPLs in any economy and mechanisms to tackle this problem. Using financial data collected from the public listing companies in China s stock market, Lu, Thangavelu and Hu (2005) empirically examine the relationship between banks lending behaviour and non-performing loans. This study takes the research strategy to infer banks lending behaviour from firms debt financing. The lending behaviour of banks is examined in a borrowing ratio model that captures the relationship between firms borrowing ratios and their default risk, collateral, state-ownership, firm size, and industrial policy. Their results show that state-owned enterprises (SOEs) got more loans than other firms, other things being equal, and SOEs with high default risks were able to borrow more than the low-risk SOEs and non-SOEs. This suggests that Chinese banks had a systemic lending bias in favour of SOEs, particularly those with high default risks, during the period under investigation. In the Indian context, Rajan and Dhal (2003) empirically examine how banks non-performing assets are influenced by three major sets of economic and financial factors, i.e., terms of credit, bank size induced risk preference and macroeconomic shocks. They estimate a panel regression model, where they take into consideration the effect of the differential social and geo-political environment confronting banks operations. Their results show that, when the bank size is measured in terms of assets, the bank size has negative impact on NPAs, while the measure of bank size in terms of capital, gives somewhat opposite result. Further, measure of credit orientation has significant negative influence on NPAs, implying that borrowers attach considerable importance to relatively more credit (customer) oriented banks. Also increased economic activity leads to lower financial distress of borrowers and this lowers NPAs for banks. The exposure to priority sector has positive impact on the NPA level. Using data on Indian manufacturing sector for 1993-94, Ghosh (2005) has examined the association between corporate leverage and banks non-performing loan. In this study asset quality of banks is modeled as a function of corporate leverage and a set of control variables, using a simultaneous equation framework. The results show that the capital adequacy of banks

275

have a significant and negative effect on asset quality. The findings further indicate that the lagged leverage is an important determinant of bad loans of banks. In terms of magnitude, a 10-percentage point rise in corporate leverage is, on an average, associated with 1.3 percentage point rise in sticky loans, with one period lag. Rajaraman and Vasishtha (2002) perform a panel regression on the definitionally uniform data for a five-year period ending 1999-2000, on non-performing loans of commercial banks. The study notes that a number of exogenous factors contribute to the general level of bank NPA in India, such as the legal and procedural obstacles the banks face in the process of liquidation of loss-making enterprises. According to the results of this study, there is no significant relation between the capital adequacy ratio and NPA; whereas, operating profit has a significant negative relation with NPA. Along with identifying the factors causing high NPA levels, an equally important issue, is how to tackle the problem of NPA. Many measures have been taken in the direction of reducing NPL. In the case of Japan, it has been argued that a financial safety net could minimize the spillover effects of failures of banks and other financial institutions on the financial system as a whole. Bank-safety-net policies could include lending to banks (a subset of lender of last resort), explicit and implicit insurance of some or all bank deposits, capital adequacy requirements, bank supervision, closure and recapitalization rules (see Diamond and Dybvig, 1983; and Allen and Gale, 2000). There are also arguments that this safety net could lead to moral hazard problem. However, in the case of Japan it has been observed that the safety net with the government financial assistance taken from DIC to Japanese banks is not the reason leading to moral hazard of increasing risk-taking incentive or bad loan, rather it helps to reduce the bad loan, especially in case of banks with high requirement capital ratio (Hanah, 2005). Similarly, in China, the government established four Asset Management Companies (AMCs) in order to deal with the NPLs of each of the four large public sector companies. Drawing on the experiences of Resolution Trust Corporation in the United States and bank restructuring in the Central European transition economies, Huang and Bonin (2001) argue that the original AMC design will not be successful in resolving the existing non-

276

performing loans (NPLs) nor will it prevent the creation of new bad loans due to various drawbacks in the policy.

4.3. The Model and Estimation Procedure (Methodology) As discussed in Chapter 1 there are two main concepts of NPA used by the banking sector, viz., gross and net NPA. Net NPA is the total NPA minus the provisions made by the bank under new accounting norms. Thus we observe that it is the gross NPA that gives an indication of total bad loans of a bank. Naturally if total advances are higher, total NPA level will also be so. Keeping these facts in mind we attempt here to understand the determinants the share of gross NPA in total advances. We consider a panel data set of 94 banks over the years 1997- 2005, as only from 1997 bank-wise NPA data are made available. Thus, in order to analyse the relation between various bank specific and economy specific variables with the level of NPA of commercial banks, an econometric model is formulated, which is estimated using panel data analysis technique. The model is given as follows:

[GNPA / GA]it = 0 + 1TAit + 2 GDP1t + 3 GDP 2 t + 4 GDP 3t + 5 LR t + 6 CRAR it + 7 RBB / TBB it + 8 NB + 9 PB + 10 FB + 11IM + i + it
Where, GNPA/GA = Ratio of Gross Non Performing Asset to Gross Advance TA = Total Assets25 GDP1 = Gross Domestic Product of Agriculture Sector GDP2 = Gross Domestic Product of Industrial Sector GDP3 = Gross Domestic Product of Service Sector LR = Lending Rate (SBI Average Advance Rate) RBB/TBB = Ratio of Rural Bank Branches to Total Bank Branches NB = dummy for private bank group PB = dummy for foreign bank group
25

(4.1)

Major aggregates of Total Asset are: Cash and Balance with RBI, Balance with Banks and money at call and short notice, Total Advance, Total Investment and Fixed Assets.

277

FB = other nationalized bank group IM= interest rate margin (between lending rate and deposit rate) i = unobserved bank specific effects which are assumed to be random (like, bank specific entrepreneurial or managerial skills) vi = stochastic term which are assumed to be identically and independently distributed, IID(0, 2). i: index for bank, t: time index Before proceeding further it is essential to discuss the rationale for including each variable in the model and also the expected signs. Total asset is included in the model as a proxy for the bank size. The relation between the bank size and NPA share is an empirical question that needs to be explored. If some kind of economies of scale exists in recovery mechanism then a bigger bank may have lower NPA share. One of the important variables that may have strong influence on the NPA level of commercial banks is the general economic condition. While GDP is usually considered to reflect general economic condition, in the present study, instead of taking total GDP, the sector wise GDPs of three important sectors viz., agriculture, industry and services sectors are included as explanatory variables. The reason for including the sector wise GDP is that the growth in various sectors is not uniform. While service sector has registered the growth rate of around 8.5 percent between 1997 and 2005, it is 5.26 and 1.99 for industry and agricultural sector. In some of the years the growth rate of agricultural sector was even negative. Thus it is essential to understand the relationship of each sector with the NPA level of commercial banks. Further, it is argued that the branch expansionary policy adopted by the government and the resulting expansion of bank branches might have led to an increase in NPA. In order to see whether the number of Rural Bank Branches (RBB) has any effect on the level of NPA, the ratio of RBB to Total Bank Branches is included in the model. One of the reasons for the loan default, as argued in the theory, is the higher cost of bank loan (Stiglitz et al, 1981). It has been argued that (Stiglitz et al, 1981) if the cost of credit is higher it will attract only the risky borrowers, which would lead to increase in the NPA level. Thus the Advance rate of SBI is included as a proxy for the lending rate. Interest rate margin is used to capture the extent of competition. Lower

278

margin may indicate higher level of competition. To examine bank group- wise differences bank group specific dummies are incorporated (taken State bank of India group as the base). The model is estimated using the panel data estimation method. One of the important decisions in a panel data analysis is whether the model should be estimated as a fixed effect model or a random effect model. Since the number of firms is more than the number of time periods, the random effect estimation technique is considered to be appropriate to estimate the model (as it will have more degrees of freedom) compared to the fixed effects model. However, if the assumption that the individual invariant effects (u it ) are not correlated with the regressors i.e., E (u it / X it ) = 0 is not valid, the GLS estimator of the random effect model becomes biased and inconsistent. In this regard Hausman (1978) has developed a test which suggests whether a fixed effect model is more appropriate than a random effect model. In the present study, the Hausman specification test recommends random effects model (see Section 4.5). When the model is estimated as a random effect model, it is essential to check for the presence of random effects. If this is negated, the model reduces to the Classical Linear Regression (CLR) model, which can be estimated using Ordinary Least Square (OLS) technique. Using the Breusch-agan test one can check the presence of random effects, which in our case gives affirmative result (see Section 4.5).

4.4. Data Description

For estimating the model given in (4.1), data are collected for 94 banks the period 1997-2005. However as many private and foreign banks are established after 1997 and few are closed during the study period, data are not available consistently for all banks for all years. Thus data used is an unbalanced panel of 94 (27 public sector banks, 33 Indian private banks and 34 foreign banks) banks for 9 years (total observation used are 746). Data on Gross Non Performing Assets as percent of Gross Advance for each bank are collected from Report on Trends and Progress of Banking in India, published by the Reserve Bank of India. Return on Assets is calculated from the data on net profit and total assets collected from Annual Accounts of Scheduled Commercial Banks published by the Reserve Bank of India. The ratio of Rural Bank Braches to Total Bank Branches is calculated from the data on total number of rural bank branches and the total bank branches collected from the Performance Highlights of Banks published by the Indian Banks Association. Data on the sector wise GDP and variables like lending rate are collected from Handbook of Statistics on the Indian Economy published by the Reserve Bank of India. The GDP measured at constant price (1993-94 base) considered for the analysis and all values are converted to real wherever applicable. A summary of the variables included in the analysis is presented in table 4.1.

Table 4.1 Summary of Data Included in the Model (mean of values, at constant 1993-94 prices)

279

Variables GNPA/TA (%) TA (Rs Crore) RRB/TBB (%) GRGDP1 (%) GRGDP2 (%) GRGDP3 (%) LR (%)

1997 5.69 8367.68 22.47 -2.43 3.05 9.87 14.00

1999 6.54 10647.93 19.52 0.31 4.05 9.86 12.00

2001 5.97 15006.05 19.59 6.28 3.51 6.49 11.50

2003 5.76 19404.87 16.81 9.60 6.52 8.87 10.25

2005 4.16 28609.90 18.28 3.93 5.90 11.30 10.25

GRGDP1 = Growth Rate of Gross Domestic Product of Agriculture Sector GRGDP2 = Growth Rate of Gross Domestic Product of Industrial Sector GRGDP3 = Growth Rate of Gross Domestic Product of Service Sector *: Return to asset ratio (measure of profitability)

4.5. Empirical results As mentioned in the previous section, before estimating the model it is important to decide whether the model should be estimated as a fixed effect model or a random effect model. In this regard the Hausman specification test is conducted and the results are presented in table 4.2. The Hausman specification test statistic fails to reject the null hypothesis that individual invariant effects (u it ) are not correlated with the regressors i.e., E (u it / X it ) = 0 . This suggests that the model should be estimated using random effect estimation technique. Table 4.2 Hausman Specification Test Results Chi2 4.33 Probability 0.7413

After deciding that the model should be estimated using random effect model, it is essential to check whether random effects indeed present in the data. If the random effects are not present in the data then the model can be estimated using Ordinary Least Squares (OLS) method. As mentioned above, presence of random effect can be checked by using Breusch Pagan test. The test results are presented in the table 4.3. Table 4.3 Breusch and Pagan Lagrangian Multiplier Test for Random Effects Chi2 1034.1 Probability 0.0000

280

The results presented in table 4.3 shows that the null hypothesis that the random effects are not present in the data is rejected, validating the use of random effect model instead of the OLS. Thus after deciding that the model should be estimated as a random effect model and confirming the presence of random effects, the model is estimated using Generalised Least Square (GLS) method. The results of the GLS estimation are presented in table 4.4. Table 4.426 Determinants of Gross NPA/Gross Advance Random-effects GLS Regression Dependent Variable: GNPA/GA Constant TA GDP1 GDP2 GDP3 IM LR RBB/TBB NB PB FB Wald Chi2(10) Prob > Chi2 R Square Within Between Overall Sigma_u = 10.768006 Sigma_e = 7.1756816 Rho
26

Coefficient Std. Err. 9.42181 15.23245 0.000091 -0.00066 0.0000487 0.000043 -0.0000171 0.0000912 -0.000009 0.0000273 0.422903 0.319696 -0.812509 0.4937 7.830 29.65196 -0.71188 5.2374 1.06269 5.0730 5.563 13.05654

Z P>|z| 0.62 -3.45 1.13 -0.19 -0.34 1.32 -1.65 3.790 -0.14 -0.21 2.35

0.536 0.0000 0.257 0.851 0.735 0.185 0.11 0.0000 0.892 0.834 0.019 746 91

81.24 Number of Observation 0.000 Number of Groups Observation Per Group 0.078 Minimum 0.238 Average 0.1736 Maximum

3 8.2 9

= 0.6924851

We have also considered various combinations of independent variables such as log of total assets , growth rates of sector-wise GDP values and so on. Qualitatively the results do not change.

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Since the model is estimated by using GLS method, the overall significance of the model is tested by using the Wald test statistic, which is essentially a Chi Square test. The Wald test statistic presented in table 4.4 shows that the model as a whole is highly significant. Further, coming to the specific relation of each variable with Gross Non Performing Asset to Gross Advance Ratio, we can note that the coefficient of the Total Asset (TA) is significant with negative sign. Since the TA variable is used as a proxy for the size of the bank, the negative sign of the TA shows that bigger banks have lesser GNPA, in relation to their gross advance. Thus there may be some economies of scale involved in loan recovery process especially when loan is given to the borrowers who may be located near to each other. Such possibilities can arise in case of agriculture loan or, of SSI loans given in a cluster. It also could be due to the reason that bigger banks have better network and more information about the customers due to which they manage their asset well, which helps them to keep the GNPA level under check. Further, it is argued in the literature that the massive branch expansion, particularly into rural areas might have led to increased GNPA levels for the commercial banks. Our result seems to support this argument. The positive sign of the RRB/TBB ratio shows that the higher rural bank braches will lead to increased GNPA in the commercial banks. One of the important variables that has strong influence on the level of GNPA of commercial banks is the economic condition. If the economy is doing well agriculturist ,industrial entrepreneurs or other borrowers will be able to repay the borrowed loan. Many studies have used GDP as a proxy for the economic condition. However, as mentioned earlier, the total GDP may not capture the differential growth rates of various sectors. Thus in the present study the GDP growth of three important sectors viz., agriculture, industry and service sector is included in the analysis. Our results justify our approach of including the growth rates of sector wise GDP. Out of the three sector wise GDP related variables all are found to be insignificant. As mentioned earlier, one of the reasons for the loan default, as argued in the theory, is the higher cost of bank loan. If the cost of credit is higher it will attract only the risky borrowers, which would lead to increase in the NPA level. In order to capture the relation between cost of bank credit and GNPA the Advance rate of SBI was included as a proxy for the lending rate in the model. However, it has turned out to be insignificant showing that interest rate on credit does not have any relation with the GNPA of commercial banks. One reason could be that the lending rate of late has already come

282

down and even though there is some variations in lending rates over the years, they are not too high to really bring risky borrowers to the lending process. Interest margin is also not found to be significant. Bank group dummies show that foreign bank dummy is positively significant. That is, while we take care of other variables like rural branches etc. there is significant difference between foreign bank and SBI in their abilities to reduce bad loans27. This result also goes with the finding that larger bank size is better for reducing bad loans28.

4.6 Sector Specific Determinants of NPA: SSI Sector We next examine the determinants of NPA at the sectoral level, especially concentrating on the SSI sector. The model under consideration is similar to the one with aggregate NPA levels, but now the dependent variable is NPA from the SSI sector as a percentage of total advances29. Thus the model under consideration is as follows. [ SSINPA / GA] it = 0 + 1 ln TAit + 2 IIPt + 3 CRARit + 4 RRB / TBBit

5 LRt + i + it
Where,

(4.2)

SSINPA/GA = Ratio of Gross SSI sector Non Performing Asset to Gross Advance ln TA = log of Total Assets IIP: Index of Industrial Production CRAR = Capital to Risk Asset Ratio RBB/TBB = Ratio of Rural Bank Branches to Total Bank Branches LR = Lending Rate (SBI Average Advance Rate) i = are unobserved bank specific effects which are assumed to be random (like, bank specific entrepreneurial or managerial skills)
27 28

This hypothesis will be checked more rigorously when we deal with efficiency issues in Chapter 5. It has been mentioned during the workshop on draft report presentation at Kathmadu by the experts that there may be endogeinity problem in the panel data estimation presented above. Therefore Hausman Wu Durbin endogeneity test has been carried out for different independent variables and the problem is not seen to be present. In the Appendix we present one such results (Table A4.1). 29 However, note that the data considered for the analysis is for the period 2001 2005, which does not include Foreign Banks.

283

vi = are stochastic term which are assumed to be identically and independently distributed, IID(0, 2). While estimating the panel data model we observe that Hauman specification test suggests a fixed effect model to be the appropriate one (Table 4.5). In a fixed effect model bank specific dummies cannot be incorporated. Thus the former model has been modified accordingly. The results based on this model reveal the following (Table 4.6).

Table 4.5 Hausman Specification Test Results Chi2 18.66 Probability 0.0022

After deciding that the model should estimated using fixed model estimation techniques, it is essential to check whether fixed effects in fact present in the data. In this regard the F test was conducted, the results of which (see table 4.6) suggest that there are fixed effect present in the data. Table 4.6 F-Test for Testing Fixed Effects F 4.72 Probability 0.0000

After deciding that the model should be estimated as a fixed effect model and confirming the presence of fixed effects, the model is estimated using Fixed Effects (Within) method. The results of the within estimation is presented in table 4.7. Table 4.7 Determinants of SSI NPA/Gross Advance Fixed-effects (within) regression Dependent Variable: SSINPA/GA Constant ln TA IIP Coefficient Std. Err. 96.9025 25.4395 -17.5737 6.6471 0.0011 0.0348 Z 3.8100 -2.6400 0.0300 P>|z| 0.0000 0.0090 0.9760 284

LR CRAR RBB/TBB F(5,198) Prob > F R Square Within Between Overall

-0.1661 0.1096 -20.4354

0.7573 0.1357 10.3834

-0.2200 0.8270 0.8100 0.4200 -1.9700 0.0500 255 52

4.38 Number of Observation 0.0008 Number of Groups Observation Per Group 0.0996 0.0011 0.0016 Minimum Average Maximum

3 4.9 5

Sigma_u = 13.035762 Sigma_e = 5.0268054 Rho = 0.87054922

The only significant variables are total asset of a bank and the share of rural branches. Large size banks have lower NPA levels, which is similar to the result we have obtained above. Importantly, larger number of rural branches appears to have a negative impact on SSI NPA. Thus rural branches are not appearing to create NPA for the sector. This is a result of some importance. While we find RBB/TBB to be positively significant in case of gross NPA , it is negatively significant in the case of SSI NPA. This can happen if the rural branches provide loans to the SSI sector in cluster and there exists some economies of scale in monitoring. The CRAR variable captures the capital to risky asset ratio. This variable is found to be insignificant in the case of SSI sector NPA. Thus an increase in so called risky assets does not seem to affect the SSI sector. It is also important to note that if we remove the CRAR variable and run the estimation , results do not change qualitatively. Only the total assets and RBB/TBB remain the significant variables, with no change in their signs as well.

4.7 Conclusion

285

In this chapter we made an attempt to study the relation between GNPA and some bank specific variables such as bank size, return on assets, the number of rural branches and also some economy specific variables such as the growth rates of sectorwise GDP and finally the lending rate. The model was estimated using panel data technique, specifically through a random effect model. Our results show that bank size contribute negatively to GNPA. One of the important findings of our analysis is that the rural bank branches have contributed for higher GNPA in commercial banks. Thus commercial banks need to focus on the loan recovery process concerning the rural branches. Such loans usually are small size ones and involve a large number of borrowers. These borrowers often need other supporting inputs from the banking sector in addition to credit. Such support may be in the form of providing necessary information about technology, management techniques, costing and so on for the SSI sector. Similar supports are necessary to the agriculture sector as well. Finally our result show that the interest rate charged on the bank credit does not have impact on the GNPA level. This indicates that current interest rates are not at a significantly high level so as to really bring risky borrowers to the bank net.

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Appendix to Chapter 4
A4.1 Hausman specification Test An important question in panel data analysis is whether to use fixed effect model or random effect model. The major drawback of the dummy variable model is that it consumes more degrees of freedom. On the other hand when random component model is estimated, it is assumed that the individual invariant effects (u it ) are not correlated with the regressors i.e., E (u it / X it ) = 0 . If this assumption is not valid then the GLS estimator of the random effect model becomes biased and inconsistent. However, this problem will not occur under fixed effect model as the within transformation wipes out the (u i ) , which makes the within estimator unbiased and consistent. In order to choose between fixed effect model and random effect model Hausman (1978) suggests comparing

GLS

and

within under

the

null

hypothesis

that E (u it / X it ) = 0 . Hausmans essential result is that the covariance of an efficient estimator with its difference from an inefficient estimator is zero (Greene 2003). And also under the null hypothesis the two estimates should not differ systematically. This is tested by a statistic given by Hausman (1978) which is essentially a chi-squared test, given by, m = ( within GLS ) / 1 ( within GLS ) ~ 2 (k)
= Var ( within GLS ) = Var ( within) Var ( GLS ) is the difference between the

estimated covariance matrix of the parameter estimates in the LSDV model (within) and that of the random effects model (GLS). It is notable that an intercept and dummy variables SHOULD be excluded in computation. If the test statistic is higher than the critical limits, the null hypothesis that individual invariant effects are not correlated with regressors is rejected. This indicates that the GLS estimators are biased which means the fixed effect model is a better choice.

A4.2 Testing Individual Effects in a Fixed Effect Model (F Test)

287

While estimating a fixed effect model one should check whether the fixed effects are present in the data or not. If the fixed effects are not present the model can be estimated using the Classical Linear Regression technique. In order to check for the presence of fixed effect, one has to test the joint significance of the individual specific dummies. In other words, one her to check the null hypothesis that 1= 2....n-1 = 0, by performing an F test, which can be calculated using the formula given below.
( RSS R RSS UR ) /( N 1) ~ FN 1, N (T 1) K RSS UR /( NT N K )

F0 =

If the calculated F statistic is higher than the critical limit, for the given degrees of freedom, then the null hypothesis that individual specific dummies are zero is rejected. In other words, there is presence of individual effect in the data.

A4.3 Breusch - Pagan Test for Random Effects

Similar to the Fixed Effects model estimation, it is essential to check for the presence of Random Effects under random effect model estimation. If the random effects are not present, the model can be estimated using the Classical Linear Regression technique. Checking for the presence of random effects is essentially testing the null
2 hypothesis that the cross sectional variance components are zero, i.e., H 0 = = 0 . For

testing this hypothesis Breusch and Pagan (1980) have developed a Lagrange Multiplier (LM) test, which can be given as (Greene, 2003):
2

nT T 2 e e LM = 1 2(T 1) e e

In the above formula, e is the n X 1 vector of the group specific means of pooled regression residuals, and e e' is the Sum of Squared Errors of the pooled OLS regression. And, the LM is distributed as chi-squared with one degree of freedom. Table A4.1 Endogeinity Test

288

Endogeinity test for rural bank branches / total bank branches Coefficient RRB_Total B.B 11.97679 RES 25.58089 GDP_Agr .0000417 GDP_ Indust -.000026 GDP_Ser -8.11 IM .3950728 IR -.8573449 NB .4839746 PB -1.277317 FB 7.345348 Total_Assets -.0000609 Constant 19.49389 F (11) Prob>F 50.94 0.0000 Std.Err. 14.14501 17.06733 .0000432 .0000913 .0000272 .3200173 .4942842 5.288751 5.299394 6.734881 .0000194 16.63522 Z 0.85 1.50 0.97 -0.28 -0.30 1.23 -1.73 0.09 -0.24 1.09 -3.14 1.17 P>[Z] 0.397 0.134 0.334 0.776 0.766 0.217 0.083 0.927 0.810 0.275 0.002 0.241 748 91 3 8.2 9

Number of Observation Number of groups Observation Per Group Minimum Average Maximum

R Square Within 0.0652 Between 0.0625 Overall 0.616 Sigma_u = 12.081546 Sigma_e = 7.343387 Rho = .73022373

289

CHAPTER 5 Non-Performing Assets and Profit Efficiency

5.1 Introduction

The Non-performing Assets of commercial banks adversely affects commercial banks in many ways, one of them being the decline in the profit of commercial banks. Higher NPA has two important impacts on the profit level of commercial banks. First, the assets that become NPA will not yield any return; second, banks have to make provisions for the NPA from the profit they earn, which further erodes their profit level. Thus it is interesting to study the relation between NPA levels and the profit efficiency in a more rigorous way. Further, may financial sector reforms introduced subsequent to the Narasimham Committee report (1991), particularly the prudential regulation norms, are expected to compel the banks to reduce the NPA level, which in turn improve the efficiency of commercial banks. Thus it of interest to study whether the efficiency of the commercial banks has improved over time, and importantly whether the reduction in NPA level has helped commercial banks to improve their efficiency. Thus in the present chapter an efficiency analysis is conducted using frontier technique, and an attempt is made to check whether NPA has any relation with efficiency. The frontier used here is the profit frontier, since profit frontier captures one of the important objectives of commercial banks namely profit maximization, and also it is expected that the NPA affects the profitability of commercial banks more than many other variables concerning the commercial banks. Given this background, the present chapter is designed as follows; Section 2 presents a brief review of literature related to various studies measuring efficiency of commercial banks. In Section 3 various methods of measuring efficiency of commercial banks using frontier method is discussed. Section 4 discusses the detailed methodology used in the present study. While Section 5 gives various sources of data used in the present study, in Section 6 the estimated results are presented. Finally, Section 7 presents the concluding observations.

290

5.2 Review of Literature

There exist a vast literature that concentrates on at the efficiency of commercial banks in India as well as other countries. However, studies looking at the efficiency of commercial banks in relation to their Non Performing Assets are very few. The issue no doubt assume considerable importance, because if there exist a relation between these two, then the policy prescriptions need to be tailored accordingly. Studies analyzing the general efficiency of commercial banks look at various aspects of commercial banks. While some studies look at the efficiency of commercial banks in producing outputs, whichever manner they are defined, some look at the profit efficiency of commercial banks and others examine the cost efficiency. Paster Perez and Quesada (1997), using a non-parametric approach together with the Malmquist index, analyse the differences in the productivity and efficiency between different European and US banking system. They further decompose the differences in productivity of different banking systems into differences in levels of efficiency (catching up effect) and level of technology (distance from the frontier). The study has found that, under the assumption of a constant returns to scale production technology, France has the highest efficiency score of (0.95) and the UK has the lowest efficiency score (0.56). Vivas (1997) analyse the effects of deregulation on the profit efficiency of Spanish savings banks over 1986-1991. Profit function is considered to be more appropriate since it reflects the joint impact of revenue as well as cost effects of deregulation. The thick frontier approach is used since it selects a relatively large subset of firms to define frontier unlike the other frontier measures which base the efficiency estimate on one or a very small subset of firms. The results suggest that the profit efficiency of Spanish savings banks, which averaged 28 percent, fell by forty percent between 1986 and 1991. Also there was no significant shift in the profit frontier itself (in other words, there was no technological change) Berger and Humphrey (2000) provide a comprehensive survey of 130 studies that conduct frontier efficiency analysis ( applying different efficiency measurement techniques) to financial institutions from 21 countries. They note that the impact of deregulation on the efficiency of banks is mixed. The overall efficiency, in these studies, is round 77% (median 82%).

291

Berger and Mester (2000) examine the possible sources of differences in measured efficiency of financial institutions, including differences in efficiency concepts, measurement methods, the number of banks considered, market, and regulatory characteristics and others. They estimate the efficiency of almost 6000 US commercial banks that were in continuous existence over the six-year period from 1990 to 1995. The study employs three distinct economic efficiency concepts cost, standard profit, and alternative profit efficiencies. The paper analyse the effects of a number of measurement methods, including use of the distribution-free approach versus the stochastic frontier approach, specification of the Fourier-flexible functional form versus the translog form, and inclusion of problem loans and financial capital in a number of different ways. Their results show that the mean cost efficiency from the preferred model is 0.868. It is found that the mean efficiencies for standard and alternative profit functions are similar to each other, however, the alternative profit function does not fit the data nearly as well as the standard profit function. Different functional forms used (translog & Fourier) yield essentially the same average level and dispersion of measured efficiency, and both rank the individual banks in almost the same order. Jonathan and Nguyen (2005) have studied the relationship between commercial bank performance and bank ownership in South East Asia (Indonesia, Korea, Malaysia, the Philippines, and Thailand) between 1990 and 2003, where, performance is measured using three concepts; alternative profit efficiency, technical change and productivity. They use four types of indicator in their study, viz., changes in governance due to bank privatization, acquisition by foreign banks, domestic M&A; and bank restructuring. Their study finds a positive relation between the performance of commercial bank and deregulation. In terms of state versus private ownership, state-owned banks are found to under-perform vis--vis their private counterparts. Furthermore, the study observes that bank privatization has raised bank performance to levels in excess of pre-privatisation era. Sensarma (2005) measures the cost and profit efficiency of the Indian commercial banks during the period 1986-2003, using Stochastic Frontier Analysis. The study finds that while cost efficiency of the banking industry increased during the period, profit efficiency underwent a decline. Also, in terms of bank groups, domestic banks appear to

292

be more efficient than foreign banks. Further Bigger banks were found to be less efficient than their smaller counterparts. Das et al, (2005) empirically estimates and then analyses various efficiency scores of Indian banks during 1997-2003 using Data Envelopment Analysis (DEA). Instead of taking a single measure of efficiency, they use multiple measures, i.e. two measures of technical efficiency, cost efficiency, revenue efficiency and profit efficiency. Their results show that there is not much difference in the technical efficiency of various banks. However, for the remaining two measures of efficiency relating to cost and profit banks appear to be more differentiated; this is particularly true with respect to profit efficiency. Also, there has been a noticeable improvement in the profit profile of banks over the years, particularly after 1999-2000. Profit efficiency seems to have a positive relation with bank size, which shows that bigger banks are more efficient. Further the results also show that there is a positive association between good management practices and profit efficiency. Their results, however, does not show any clear association between the efficiency of commercial banks and their privatization. Mohan and Ray (2004) compare the performance among public sector banks, private banks and foreign banks using physical quantities of inputs and outputs, and comparing the revenue maximization efficiency of banks during 1992-2000. The findings show that PSBs performed significantly better than private sector banks but no differently from foreign banks. The study also finds that there is a convergence in performance between public and private sector banks in the post-reform era. De (2004) has empirically investigated the interrelation between ownershipliberalisation-efficiency of the Indian banking industry using a panel data set for the years 1985-86 to 1995-96. The study estimates time-invariant and time-variant technical efficiency levels of the banks in the Indian banking industry using a stochastic frontier production function by incorporating the Cobb-Douglas technology with four inputs and two alternative measures of output. The overall finding is that banking industry is technically inefficient. The average inefficiency levels are 55 percent and 20 percent for the two output measures used in the study. Technical efficiency has increased, in the post-liberalisation for only 14 banks out of 18 banks, and, for more than two-third of the banks in our sample technical efficiency is constant over the period.

293

Studies discussed above only concentrate on measuring the performance of commercial banks through profitability, technical efficiency and/or productivity. However, in the recent time it is being recognized by many that NPA has strong implications on the performance of commercial banks. Though the issue of relation between NPA and the performance of commercial banks has not been explored sufficiently, there are few attempts in this direction. Berger and Young (1997) have made one of the early attempts to analyse the relation between NPA (or problem Loans, as they call it). They employ Granger-causality techniques to test four hypotheses regarding the relationships among loan quality, cost efficiency, and bank capital. The four hypotheses they test are; bad luck, bad management, skimping and moral hazard. The results of their analysis suggest that the intertemporal relationships between loan quality and cost efficiency run in both directions. Further provide support for the bad luck hypothesis increases in nonperforming loans tend to be followed by decreases in measured cost efficiency, suggesting that high levels of problem loans cause banks to increase spending on monitoring, working out, and/or selling off these loans. For the industry as a whole, the data favor the bad management hypothesis over the skimping hypothesis, however, for a subset of banks that were consistently efficient across time, the data favor the skimping hypothesis. Their results also support the moral hazard hypothesis, and suggest that, on an average, thinly capitalized banks take increased portfolio risk, which results in higher levels of problem loans in the future. Dongili and Zago (2005) estimate the technical efficiency of Italian banks by taking into account problem loans and using directional distance functions. Their results show that once problem loans are taken into account, the economic efficiency of banks increase significantly, suggesting that a significant aspect of banking production, credit quality, needs to be considered when evaluating banks performances. Jordan (1998), examine whether the increase in the problem loans of the banks of New England is because of the inefficiency of commercial banks or because of the government policies. In order to determine the reason for the severity of the problem an analysis of cost and profit efficiencies are conducted using parametric method. In general, the data suggest that no relationship exists between cost efficiency and problem loans, but

294

they show a positive and statistically significant relationship between profit efficiency and problem loans. Further, this study finds that higher levels of profit efficiency in the 198488 periods are associated with higher levels of problem loans in the 198992 periods. These results suggest that managers of these profit-efficient banks deliberately adopted policies designed to generate higher returns, but by taking higher risk. Matthews, Guo and Zhang (2006) analyse the relation between rational inefficiency and non-performing loans of Chinese banking industry using boot-strapping method. They argue that inefficiency relative to 'best practice' is usually blamed on bad management, rent seeking behaviour and poor motivation not just X-inefficiency in the traditional sense. Das and Ghosh (2005) examine the interrelationships among credit risk, capital and productivity change in the Indian context, using the data on state-owned banks (SOBs) for the period 1995-96 through 2000-01, where credit risk is measured by the ratio of net non-performing loans to net advances. Their results show that higher productivity leads to a decrease in credit risk, and also there is a positive relation between productivity and bank capitalization. This finding supports the fact that poor performers are more prone to risk taking than better performing banking organizations. Their results also reveals that efficiency, capital and risk taking tend to be jointly determined, reinforcing and compensating each other.

5.3 Measuring Efficiency

Efficiency has two components: one is purely technical or physical component which refers to the ability to avoid waste by producing as much output as input usage allows, or by using as little input as production allows. Thus the analysis of technical efficiency can have an output augmenting orientation or input conserving orientation. Another is the allocative or price component, which refers to the ability to combine inputs and outputs in optimal proportion in the light of prevailing prices (Lovell, 1993) Koopmans (1951) was the first to provide a formal definition of technical efficiency. According to his definition a producer is technically efficient if an increase in any output requires a reduction in at least one other output or an increase in at least one input, and if a reduction in any input requires an increase in one other input or a reduction in at least one out put. Thus technically inefficient producer could produce the same outputs with less of at least one input, or could use the same inputs to produce more of at least one output. The basic assumption underlying the measurement of technical efficiency is that a gap normally exists between a firm's actual and potential levels of technical performance. This can be understood from the diagram 1, given in the next page. In the diagram, the FF curve represents the frontier which is the combination of outputs of the best performing firms in the sample. According to the neo-classical theory, all firms operating on this frontier are technically efficient (Kalirajan and Shand, 1994). A firm

295

operating at point B, which is on the frontier, will produce Y*1 outputs, which is the maximum possible output for a given set of inputs X1. Thus the firm operating at point B is technically efficient. . Diagram 1

Measuring Efficiency
Y

F Y*1 Y1 B A

F X 0 X1

However in practice a firm may not be working at a point on the frontier due to various reasons such as incomplete knowledge of the best technical practices or other factors that prevent it from operating on its technical frontier. Thus the firm will operate on an actual or perceived production function, which is below the potential frontier. The firm operating at point A is technically inefficient as it is producing output Y1 which is less than the maximum possible output for the input vector X1. Now, the technical efficiency of the firm operating at point A is measured by the distance between its actual output and the maximum possible output (which is given by the frontier at B). Thus the technical efficiency can be measured as the ratio Y1/Y*1. The most commonly used tool of analysis for measuring technical efficiency is the primal production function. In the neoclassical theory of production, the primal production function defines the maximum possible output of a firm for combinations of inputs and technology, i.e., it is frontier production function. The production frontier of the firm, producing a single output with multiple inputs can be defined as,

y i = f ( xi ; )

(1)

Where, yi and xi are output and inputs of the ith firm. Here the firm is operating on the frontier, producing maximum possible output, thus there is no technical inefficiency. But in reality this may not be the case. A firm, say the ith firm may not be producing its maximum possible output. Then the production function of ith firm can be written as,

y i = f ( x i ; ) TE i

(2)

296

Where, TEi is the technical efficiency of the ith firm which represents the combined effects of various non-price and organisational factors which constrain the firm from obtaining its maximum possible output. The value taken by TEi depends on the extent to which the firm is affected by constrains. A measure of technical efficiency of the firm can be defined as.

TE i =

yi f ( xi ; )

(3)

The above model is a basic model generally used for measuring technical efficiency. Here yi achieves its maximum possible level only if TEi = 1. In this model, the numerator is observable but the denominator is not. Various methods using different assumptions have been suggested in the literature to estimate the denominator and there by TEi. Farrell (1957), who gave the definition of efficiency, also suggested that the production frontier can be can be estimated from sample data using either a non-parametric piece-wise-linear method or a parametric function, such as the Cobb-Douglas form. Since then the basic model has been extended by many ways. Various methods of estimating frontier production function, and thus technical efficiency, can be conveniently grouped under two major groups, namely, programming (deterministic) and statistical (stochastic) methods.

The classification of

different frontier production function methodology is given in the chart 1.

Chart 1
Frontier Methodology

Deterministic

Stochastic

Non Parametric

Parametric

Neutral Shift

Non Neutral Shift

Programming

Statistical

Cross Section

Panel Data

Time Variant

Time Invariant

Deterministic Approach:

297

Farrell pioneered the work on the deterministic approach of measuring technical efficiency in 1957, following the notion of Debreu (1951) and Koopmans (1951). He assumed constant returns to scale to estimate the frontier production function, and the model included one out put and two inputs. This model was extended to one output and m-inputs, and a functional form, Cobb-Douglas, was specified by Aigner and Chu (1968). The principal disadvantage of Farrell model is the assumption of constant returns to scale, which is quite restrictive. This was extended to increasing returns to scale by Seitz (1970). The Farrell model was generalised in terms of vector inputs and vector outputs by Carnes,et,al (1978), which is Known as Data Envelopment Analysis (DEA). DEA was further developed by Varian (1985) who incorporated stochastic characteristics. The aim was to introduce two sided deviations to include random noise and to calculate the efficiency measures free of such random noise. Land,et.al (1980) provided an alternative approach to Varian by allowing deterministic frontier to capture the effects of random noise without themselves becoming stochastic. In literature this method is termed as chanceconstrained efficiency analysis.

Stochastic Frontier Approach: The programming method does not take into account the statistical errors. This was first pointed out by Timmer (1971) who provided a simple method to deal with these errors. The full fledged stochastic frontier production function estimation was first published by Aigner,Lovell and Schmidt and Meeusen and Van den Broeck independently in 1977. Aigner, et.al used a truncated normal (half normal) distribution for u, whereas Meeusen and Van den Broeck used exponential for the same. However, this stochastic frontier production function approach could only provide average technical efficiency measures for the sample observations. Although these aggregate measures are useful in a way, individual observation-specific technical efficiency measures are more useful from a policy viewpoint. Jondrow et,at (1982) and Kalirajan and Flinn (1983) independently considered the stochastic model introduced by Aigner et,al (1977) and Meeusen and Broeck (1977) to predict the combined random variable (ui+ vi). Estimation of the stochastic frontier production function for a single cross-section requires the explicit specification of distribution of statistical noise and inefficiency variable term. Several distributions have been considered in the literature, although the most commonly employed are the positive half normal and the exponential. Much of the criticism surrounding these estimates of the production frontier have been concerned with the strength of the distributional assumptions. Such strong assumptions are not required when panel data are available. Schmidt and Sickles (1984) have used panel data to estimate production frontiers. The panel data model can be a fixed effect model or random effect model; it can have time invariant effect and also time varying effect.

The Stochastic Varying Coefficient Frontier Approach: Under both approaches discussed above, the firm obtains its frontier potential output by following the best practice techniques, given the technology. In other words, frontier output is determined by the method of application of inputs, regardless of levels of inputs. Empirical evidence shows that with the same levels of inputs, different levels of actual output are obtained by following different methods of application. This implies that the different methods of applying various inputs will produce different outputs. This means that diversity of individual decision making behaviour leads to variation in production response coefficients, which include not only the intercept but also slope coefficients, across units and over time for the same unit. This idea was first appreciated by Nerlove (1965) and was later popularised by Swamy (1970). Kalirajan and Obwana (1994) showed that this method facilitates the estimation of firm specific and input specific technical efficiency values. Kalirajan and Shand (1994) discuss the modelling of the frontier production function with cross sectional heterogeneity in slopes and intercepts.

5.4 Methodology

Efficiency analyses in the present study are of two kinds. First, we analyse the impact of NPA on the efficiency of commercial banks, in particular on the profit

298

efficiency of commercial banks. Second, we analyse the efficiency of commercial banks in minimising the NPA, where NPA is considered as a bad output. Further we also analyse the factors that determine the NPA inefficiency. In order to analyse the impact of Non Performing Assets on the profit efficiency of commercial banks, we need to first obtain the profit efficiency measures using stochastic frontier method. Then the impact of NPA on the profit efficiency will be analysed by regressing the profit efficiency estimates over NPA along with a set of other control variables. In order to analyse the NPA efficiency of commercial banks, a NPA frontier is estimated using the available data, and the NPA efficiency is derived as the ratio of minimum NPA/Actual NPA, where the minimum NPA is given by the frontier30.
In the present study efficiency is estimated using the stochastic frontier analysis. The basic model of the SFA was discussed in the previous section. This basic model has been extended by number of ways. Earlier approaches were using a two stage estimation procedure, where, in the first stage firm-level efficiencies were predicted using stochastic frontiers and in the second stage they (firm-level efficiencies) were regressed upon some firm-specific variables to identify some of the reasons for differences in predicted efficiencies between firms. Though this procedure was useful in estimating firm-level inefficiencies, this was considered as inconsistent in its assumptions regarding the independence of the inefficiency effects in the two estimation stages [Kumbhakar, Ghosh and McGukin, 1991; Reifschneider and Stevensosn, 1991]. To overcome this problem Battese and Coelli (1993) proposed a model in which inefficiency effects are expressed as explicit function of a vector of firm specific variables and a random error. Present study follows the approach used by Bettese and Coelli (1993). The frontier specification used to derive efficiency estimates can be given as follows;

ln P = b0 + b1 ln ADit + b2 ln INit + b3 ln Wit + b4 ln Dit + b5T it + b12 ln ADit ln INit + b13 ln ADit ln Wit + b14 ln ADit ln Dit + b23 ln INit ln Wit + b24 ln INit ln Dit + b34 ln Wit ln Dit + (1 / 2) [b11 ln AD2 + b22 ln IN 2 + b33 ln W 2 + b44 ln D2 ] + vit uit
Where, P is the Net Profit31 AD is the Advance (output) IN is the Investment (output) (4)

30

Note that, this method is similar to the method of measuring cost efficiency. However, here the functional form used is a production function, not cost function. It is assumed that commercial banks minimize their NPA level, given the input level. 31 Note that the dependent variable for the profit function is [ + ||min + 1], where ||min is the absolute of the minimum value of net profit () over all banks. Since the net profit of most banks are negative the constant [||min +1] is added to every firms net profit so that the natural logarithm is taken of a positive number.

299

W is the wage to capital price ratio (input price) D is the deposit price to capital price ratio (input price) T is the time trend Vit are random variables, which are assumed to be iid. N (0, v2) and Uit are non-negative random variables which are assumed to inefficiency in production and are assumed of the N (mit, u2) distribution; Where; mit = zit, inefficiency of a firm estimated. independent of Uit account for technical to be independently distributed as truncations at zero

Where; zit is a 1 x p vector of variables which may influence the and is a p x 1 vector of parameters to be

The parameterization from Battese and Corra (1977) are used replacing v2 and u2 with 2 = v2 + u2 and the parameters are estimated by ML approach32.

Further, in order to analyse the impact of NPA on the efficiency levels of commercial banks, the estimates of technical inefficiency (Ui) are regressed over NPA along with a set of control variables. The functional form used to analyse the impact of NPA on the inefficiency of commercial banks can be given as follows33;

U it = 0 + 1GNPA / GA + 2 TA + 3 RBB / TBB + 4 IM + 5 GDP + 6 NB + 7 PB + 8 FB + Wit

Where, U is the Profit Inefficiency GNPA/GA is the ratio of Gross Non Performing Assets to Gross Advance TA is Total Assets RBB/TBB is the ratio of Rural Bank Branches to Total Bank Branches IM is the Interest Margin (Measured as the difference between lending rate and deposit rate). GDP Gross Domestic Product NB, PB, and FB are bank group specific dummies for Nationalised Banks, and Foreign Banks respectively
34

(5)

Private Banks

32 33

The log-likelihood function is given in Battese and Coelli (1993) Note that under Bettese and Coelli approach both frontier and inefficiency equation are estimated simultaneously using ML method. 34 The State Bank of India and Associates (SBI&A) dummy is not considered in order to avoid dummy variable trap. Therefore, the specified dummy variables should be interpreted in comparison to the SBI&A, which serves as the base.

300

As mentioned before, apart from analysing the impact of NPA on the profit efficiency of commercial banks, an attempt is also made to analyse the efficiency of commercial banks in minimising the NPA level. Here NPAs are considered as output that commercial banks actually try to minimise. However, this is difficult to estimate in a straightforward manner due to non-availability of statistical package. In order to measure the NPA efficiency, first a production frontier is estimated considering NPA as the output, using the standard production frontier approach, under which, the firm that produces the maximum output, (given a set of input and technology) will be the most efficient one. This firm then can equivalently be interpreted as the one that is least efficient in reducing NPA with a given level of inputs. The frontier used to derive the NPA efficiency can be specified as follows:

ln GNPA = a0 + a1 ln Kit + a2 ln Lit + a3 ln M it + a4T it + a12 ln Kit ln Lit + a13 ln Kit ln M it + a23 ln Lit ln M it + (1/ 2) [a11 ln Kit + a22 ln Lit + a33 ln M it ] + vit uit
2 2 2

(6)

Where, Y is Gross Non Performing Assets K is Capital (fixed assets) L is Labour (employees) M is Material (stationery, postage etc) T is the time trend Vit are random variables, which are assumed to be iid. N (0, v2) and Uit are non-negative random variables which are assumed to inefficiency in production and are assumed of the N (mit, u2) distribution; Where; mit = zit, inefficiency of a firm estimated. independent of Uit account for technical to be independently distributed as truncations at zero

Where; zit is a 1 x p vector of variables which may influence the and is a p x 1 vector of parameters to be

The parameterization from Battese and Corra (1977) are used replacing v2 and u2 with 2 = v2 + u2 and the parameters are estimated by ML approach35.

Further, the functional form used to analyse the determinants of NPA efficiency can be given as follows;

U it = 0 + 1TA + 2 RBB / TBB + 3 IM + 4 GDP + 5 LR + 6 NB + 7 PB + 8 FB + Wit

(7)

35

The log-likelihood function is given in Battese and Coelli (1993)

301

Where, U is the NPA inefficiency estimates TA is Total Assets RBB/TBB is the ratio of Rural Bank Branches to Total Bank Branches IM is the Interest Margin (Measured as the difference between lending rate and deposit rate). GDP Gross Domestic Product LR Lending Rate NB, PB, and FB are bank group specific dummies for Nationalised Banks, and Foreign Banks respectively36 W : random error. Private Banks

Before proceeding further, it is essential to discuss the rationale for including each variable in the profit inefficiency equation as well as NPA efficiency equation. In the profit inefficiency equation, the first variable on the right hand side of the equation is the ratio of Gross Non Performing Assets to Gross Advance. Since higher level of NPA calls for higher level of provisioning, it affects the profit level of commercial banks. Thus the GNPA/GA is expected to have a negative impact on the profit efficiency. Total assets represent the size of the bank. It is interesting to know whether size of the commercial banks has any impact on the efficiency levels of commercial banks. Though the relationship between the bank size and efficiency level is an empirical question, since bigger banks would have economies of scale, size of bank can be expected to have a positive relation with the efficiency level of commercial banks. It has been argued that branch expansion policy followed by RBI and the resulting expansion of commercial banks branches in the rural areas has adversely affected the efficiency of Indian commercial banks. Thus it is important to understand the relationship between the rural bank branches and the efficiency level. In this regard the ratio of rural bank branches to the total bank branches has been included in the inefficiency equation. An important development in the post-liberalisation period is the increasing competition. It has been argued by many that the competition increase the efficiency of commercial banks. Thus in order to capture the impact of competition on the efficiency of commercial banks, the Interest Margin (IM) is included in the study. The rationale for including IM as a measure of competition is as follow; when the competition increases, it increases the pressure on the competing banks to minimise the margin they receive by financial intermediation. Thus when the IM is declining it indicates that the competition is increasing. One more important variable that has strong influence on the efficiency of commercial banks is the economic condition. Higher economic growth means higher productivity, which will lead to higher financial transaction, which in turn will lead to higher profit efficiency of commercial banks. Thus GDP, which is included to capture the economic condition, is expected to have a positive impact on the profit efficiency of commercial banks. The bank group specific dummies are included to capture the bank group specific characteristics that can have influence on the profit efficiency of commercial banks. Coming to the NPA efficiency equation, most of the variables are similar to the ones included in the profit inefficiency equation. Here also, total asset is included as a size variable. Similar to the case of profit inefficiency equation, here too the ratio of rural bank branches to total bank braches is included in order to capture the effect of the branch expansion policy of the RBI and government on the NPA level of commercial banks. Increasing competition would compel commercial banks to reduce their NPA level, thus Interest Margin (IM), which is included as a proxy for the competition is expected to have a positive relation with NPA (reduction) efficiency37. Further, an improvement in the economic condition would enable the firms to repay the borrowed loans, which in turn would reduce the NPA level of commercial banks. Thus GDP is expected to have a positive relation with NPA reduction
36

The State Bank of India and Associates (SBI&A) dummy is not considered in order to avoid dummy variable trap. Therefore, the specified dummy variables should be interpreted in comparison to the SBI&A which serves as the base. 37 By NPA efficiency here we mean efficiency in reducing NPA levels.

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efficiency. An important variable that is expected to have strong implications on the NPA of commercial banks is the Lending Rate (LR). In this regard the SBI advance rate is included in the NPA inefficiency equation as a proxy for the LR. Finally the bank group specific dummies are included to capture the bank group specific characteristics that can have influence on the profit efficiency of commercial banks.

5.5 Sources of Data

Data are collected for the period 1997-2005. However as many private and foreign banks are established after 1997 and few are closed during the study period, data are not available consistently for all banks for all years. Thus data used is an unbalanced panel of 94 banks (27 public sector banks, 33 Indian private banks and 34 foreign banks) for 9 years (total observation used are 746). Banks are grouped into four groups38 (i) State Bank of India and Associates (SB & A) (ii) Nationalised Banks (NB) (iii) Private Banks (PB) and (iv) Foreign Banks (FB). Net profit is measured as Gross Profit less (-) provisions and contingencies. Advances are measured as total advances and Investments are measured as total investment. Data on net profit, advances and investment are measured in value terms and are collected from Annual Accounts of Scheduled Commercial Banks published by Reserve Bank of India. Price of labour (employees) is obtained by dividing the total expenditure on employees by total number of employees and the price of capital is obtained by = (total operating cost total expenses on labour)/total fixed assets39. Price of deposits is obtained by dividing the total interest expenditure on deposits by total deposits. Further, fixed capital (or capital stock, (K)) is the sum of premises, furniture and other fixed assets40. Number of employees (or Labour (L) is measured as the total number of employees which include officers, sub-ordinates and clerks. Material (M) is measured as the sum of expenditure on printing & stationeries and postage, telegrams & telephones etc. while data on the fixed capital and material is collected from the balance sheet of commercial banks, presented in Annual Accounts of Scheduled Commercial Banks, data on the number of employees are collected from Statistical Tables Related to Banks in India, both documents published by Reserve Bank of India

5.6 Empirical Results

The focus of the present study is to analyse the relation between the Gross NonPerforming assets and the efficiency levels of commercial banks. Thus emphasis will be given on the estimates of the inefficiency equation (equation 5). However, measurement of efficiency is a pre-requisite to understand its relation with the GNPA of commercial banks, it would be interesting to have a look at the efficiency levels of commercial banks before proceeding further. The estimated coefficients of the profit frontier are presented in the appendix (Table A5.1). It can be seen from the table that majority of the coefficients are significant. The value of the gamma shows that majority of residual

38 39

This grouping is done following the standard classification of RBI Similar method is used by Kumbhakar and Sarkar (2003) 40 Capital stock is converted into its present value using perpetual inventory method

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variation is due to the inefficiency effect41. An interesting observation is that the value of the time trend shows that there is technical progress in the Indian commercial banks. The profit efficiency estimates obtained using the profit frontier are averaged across bank group for each year and are presented in table 5.1. Table 5.1 Profit Efficiency Estimates
Year 1997 1998 1999 2000 2001 2002 2003 2004 2005 Average SB&A 0.9022 0.9106 0.8706 0.8649 0.8670 0.8582 0.8537 0.8957 0.9152 0.8820 NB 0.9217 0.9768 0.9688 0.9618 0.9408 0.9439 0.9466 0.9631 0.9709 0.9549 PB 0.9667 0.9711 0.9551 0.9621 0.9517 0.9552 0.9524 0.9611 0.9691 0.9605 FB 0.7742 0.7645 0.7008 0.6878 0.7153 0.6879 0.6794 0.7456 0.7817 0.7264 TBS 0.9578 0.9677 0.9581 0.9548 0.9342 0.9418 0.9502 0.9651 0.9749 0.9561

After estimating the profit frontier, profit efficiency is estimated as the ratio between actual profit (profit of bank i) and the maximum possible profit (profit of the best performing bank in the sample). The average profit efficiency of the total banking sector, for the total study period is 0.956, which means that Indian commercial banks are around 96 percent efficient in earning profit in relation to the best performing bank. In other words, Indian commercial banks are loosing around 4 percent of the net profit due to technical inefficiency. At the bank group level private banks are the most efficient bank group with an efficiency estimate of around 96 percent followed by Nationalised banks with an efficiency estimate of around 95 percent. SBI&A rank third in terms of profit efficiency with an efficiency estimate of around 88 percent and foreign banks are the least efficient banks with an efficiency estimate of around 78 percent. The reason for private banks being most efficient is, their non-interest income is higher than public sector and foreign banks, which is mainly because they focus more on providing fee based services than conventional banking activities.
A value zero for gamma indicates that the deviations from the frontier are due entirely to noise, whereas a value of one would indicate that all deviations are due to technical inefficiency. Gamma is estimated as; =2/s2; where 2 is the variance of ui (inefficiency term), and s2 is total variance (variance of vi plus variance of ui).
41

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Now we move on to the important question of this chapter, i.e., the impact of GNPA on the profit efficiency of commercial banks. As discussed in section 5.4, the impact of GNPA on the efficiency of commercial banks is analysed by regressing the profit efficiency estimates over the GNPA/GA ratio along with some of the control variables. The results of the regression are presented in table 5.2.

Table 5.2 Determinants of Profit Inefficiency

Constant GNPA / Gadv Total Asset RBB/TBB IM GDP NB PB FB Coefficient -1.1933 0.0047* -0.1627* -0.2555 0.0612** -0.4408*** 0.6291** -0.1749 2.368481* StandardError 1.8230 0.0010 0.0309 0.1895 0.0155 0.2561 0.2320 0.2993 0.396584 t-ratio -0.6546 4.7355 -5.2667 -1.3484 3.9455 -1.7213 2.7110 -0.5844 5.972209

*, **, *** :- Significant at 1%, 5% and 10% respectively Results presented in table 5.2 shows that majority of the coefficients are significant and the signs are according to expectation42. The coefficient of GNPA/GA ratio is significant with positive sign. This shows that GNPA/GA ratio has a positive relation with profit inefficiency, which means that when the GNPA as a ratio of Gross Advance increases the profit inefficiency of commercial banks will increase. This shows that Gross Non Performing Assets adversely affect the efficiency of commercial banks. Further the coefficient of Total Asset is significant with negative sign. This shows that size of commercial bank has a negative relation with profit inefficiency. In other words, bigger banks are more efficient compared to smaller banks in the sample in terms of earning higher profit. This could be because since bigger banks can lend more loans, they can diversify their risk, due to which handle the loss arising through loan loss. As
42

Note that since the inefficiency equation is estimated simultaneously with frontier, the goodness of fit statistic presented in table A5.1 in appendix also serves as the goodness of fit statistic of the results of inefficiency estimation presented in table 5.2.

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mentioned earlier, one of the argument in the literature is that the expansionary policy followed by the RBI in terms of expanding branch network has adversely affected the efficiency of commercial banks. Our results, however, does not seem to provide any evidence in favour of such argument. This could be due to the reason that the time period considered for our analysis falls in the post-liberalization period, where many of the branch licensing policies has been amended due to which many loss making rural bank branches have been closed. One of the important developments in the post-liberalisation period is the increasing competition, which is expected to increase the efficiency of commercial banks. The coefficient of Interest Margin being significant, with positive sign, supports this argument. As mentioned earlier, when the competition increases it increases the pressure on commercial banks to cut down on the interest margin they earn. Thus a declining IM is an indication of increasing competition. The positive sign of IM shows that when the IM declines (i.e., competition increases) the inefficiency also declines (i.e., efficiency increases). Further, the coefficient of the GDP has a negative sign indicating that an improvement in the economic condition of the country will help the commercial banks to reduce their inefficiency level. As mentioned earlier, the NPA efficiency presented in table 5.3, using the standard production frontier approach. Results of the NPA frontier are presented in the appendix. As can be seen from the table A5.2, majority of the coefficients are significant. The value of the gamma shows that majority of residual variation is due to the inefficiency effect. After estimating the NPA frontier, Table 5.3 NPA Efficiency Estimates 1997 1998 1999 2000 2001 2002 2003 2004
SB&A 0.8978 0.9109 0.926 0.9238 0.9248 0.9131 0.8902 0.8562 NB 0.8971 0.9019 0.9128 0.9149 0.9227 0.9309 0.9297 0.9226 PB 0.6047 0.6401 0.7199 0.7448 0.7787 0.8041 0.8073 0.7879 FB 0.4234 0.5101 0.5405 0.5346 0.5624 0.5402 0.5403 0.5462 Total 0.6536 0.6864 0.7191 0.7221 0.7508 0.7502 0.7465 0.7534

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2005 Average

0.8406 0.8982

0.9032 0.9151

0.7766 0.7405

0.5281 0.5251

0.7426 0.725

The average efficiency estimate of the total banking sector for the total study period is around 0.72. This shows that Indian commercial banks are around 72% percent efficient in incurring NPA compared to the bank, which is most efficient in incurring NPA (or least efficient in reducing NPA). It was observed in the case of profit efficiency that, Private Bank group was the most efficient bank group followed by the NB and SB&A. This order seems to have changed in the case of NPA efficiency. Here, Foreign Banks are the most efficient bank group in reducing NPA as they have the lowest score on an average; followed by Private Banks (PB). The SB&A and Nationalised Banks are the least efficient banks in reducing NPA with high efficiency scores in incurring NPA (table 3). It is worth noting in this context that NB holds the highest amount of NPA, in absolute terms as well as percent of gross advance, compared to other bank groups. Looking at the temporal behaviour, the NPA efficiency of the total banking sector has declined steadily from 1997 till 2001, and remained almost stable there thereafter. From 1997 till 2002, this trend of NPA efficiency follows the trend of the GNPA of total banking industry, which has increased steadily from Rs 50815 crores in 1997 to Rs 70861 crores in 2002 (in real terms), and thereafter since 2002 GNPA has declined then reached Rs 58299 crores in 2005. NPA efficiency scores have remained almost stable in this period. At the bank group level the temporal behaviour of the NPA efficiency is not uniform. The SB&A group has shown increase in efficicny in reducing NPA. This is however, not seen to be true for the nationalized banks . Private banks efficiency scores also show a fluctuating trend. The temporal behaviour of the NPA efficiency of FB is distinct from other bank groups. It has remained more or less stable over the period. We next move on to another interesting question, viz., what are factors that have influence on the NPA efficiency level. In this regard, the NPA efficiency equation is estimated, along with the frontier, where the NPA efficiency estimates are regressed over a set of variables, which are expected to have influence on the NPA efficiency of commercial banks (Table 5.4).

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Table 5.4 Determinants of Efficiency in reducing NPA Coefficient Standard-Error t-ratio Constant -6.0298 4.9092 -1.2283 Total Asset -1.0925* 0.0847 -12.9054 RBB/TBB -4.2486* 0.8343 -5.0922 IM 0.0041 0.0235 0.1745 GDP 0.7617 0.7340 1.0377 LR 0.3159* 0.0656 4.8158 NB -0.5196* 0.0979 -5.3054 PB 1.0243* 0.2934 3.4905 FB 0.9384* 0.3378 2.7776 * - Significant at 1%, ** - Significant at 5% Total Assets is having a negative relation with NPA reduction efficiency, which means bigger banks are less efficient in minimizing their Gross Non Performing Assets. The ratio of rural bank branches to total bank branches also has a negative relation with NPA reduction efficiency, which means, when the rural bank branches are increasing, the NPA efficiency declines. This also shows that banks, which have higher rural bank branches, are less efficient in minimizing their GNPA. Competition and rate of interest also do not seem to have any impact on the NPA efficiency. Similarly, GDP also does not seem to have any impact on the NPA efficiency. Bank

308

group dummies show that, NB is less efficient than SB&A whereas PB and FB are more efficient than SB&A43.

5.7 Conclusion Non Performing Assets adversely affect the efficiency of commercial banks. In particular higher NPA has strong implications on the profitability of commercial banks. On the one hand the assets that become NPA will not yield any return; on the other hand, banks have to make provisions for the NPA from the profit they earn, which further erodes their profit level. Thus higher NPA has strong implication on the profit efficiency of the commercial banks. In the present chapter an attempt is made to understand the relation between Gross Non Performing Asset to Gross Advance ratio and the profit efficiency of commercial banks and also to analyse the efficiency of commercial banks in minimizing the Gross Non Performing assets. The relation between GNPA/GA and profit efficiency is analysed by regressing the profit efficiency estimates, obtained through frontier analysis, on the GNPA/GA ration along with some of the control variables. And, the efficiency of commercial banks in minimizing the GNPA level is analysed by estimating the NPA efficiency through GNPA frontier, where GNPA is considered as a bad output and it is assumed that banks try to minimize it. Our results suggest that GNPA/GA ratio has significant relation with profit efficiency of commercial banks. The sign of the GNPA/GA ratio show that when the GNPA/GA ratio increases the profit efficiency
43

Note that since SB&A dummy is not included in order to avoid a dummy variable trap, rest of the bank group specific dummies should be interpreted with reference to SB&A.

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of commercial banks also increases. Our results also show that bigger banks are more efficient in terms of earning profit however, they are less efficient in minimizing the GNPA level compared to smaller banks. Further, the analysis suggests that while the higher proportion of rural bank branches does not have any impact on the profit efficiency of commercial banks, it does affect the NPA efficiency adversely. Contrary to the result of rural bank branches, the coefficient of IM shows that increasing competition lead to increased profit efficiency of commercial banks, which however, does not seem to have any impact on the NPA efficiency. Finally, the improvement in the economic condition of the country will help the commercial banks to improve their profit efficiency, whereas it does not seem to have any impact on the NPA efficiency44.

Appendix To Chapter 5
Table A5.1 Profit Frontier Estimates
Constant Adv Inv W
44

Coefficient 4.8865* 0.0089 -0.2289** 0.2151**

Standard-Error 0.0877 0.0897 0.0882 0.0662

t-ratio 55.7394 0.0989 -2.5941 3.2471

It must be kept in mind that these are preliminary set of results, which will be again re-checked.

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D 0.7442* Adv2 -0.0047 Inv2 -0.0153 W2 -0.0102 D2 0.0643 Adv*Inv 0.0558 Adv*W 0.0992** Adv*D -0.1210** Inv*W -0.1207** InvD 0.1656** W*D -0.1178** T 0.0107* sigma-squared 0.1308* Gamma 0.9932* Log likelihood function = LR test of the one-sided error =

0.0916 0.0257 0.0332 0.0202 0.0495 0.0569 0.0374 0.0545 0.0364 0.0540 0.0385 0.0014 0.0099 0.0011

8.1262 -0.1822 -0.4627 -0.5031 1.2983 0.9809 2.6539 -2.2193 -3.3170 3.0662 -3.0615 7.9187 13.2378 895.8645 818.6481 1195.1023

*, **, *** :- Significant at 1%, 5% and 10% respectively Table A5.2 NPA Frontier Estimates
Dependent Variable - log(GNPA) Coefficient Standard-Error t-ratio Constant 2.3048* 0.2796 8.2431 ln PC 0.1093 0.1867 0.5857 ln L -0.2354 0.2556 -0.9207 ln M -0.6550** 0.2711 -2.4164 ln PC2 0.3355* 0.0632 5.3087 2 ln L 0.0250 0.0589 0.4252 ln M2 -0.2350*** 0.1278 -1.8393 ln PC*ln L -0.1320*** 0.0764 -1.7269 ln PC*ln M -0.5369* 0.1467 -3.6597 ln L*ln M 0.6238* 0.1263 4.9393 Time 0.0100*** 0.0051 1.9680 sigma-squared 0.4588* 0.0457 10.0386 gamma 0.9578* 0.0062 154.6655 log likelihood function -105.4861 LR test of the one-sided error 487.4373

*, **,:- Significant at 1%, and 5% respectively

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CHAPTER 6 Problem of Loan Repayment: Views of the SSI Units

6.1 Introduction

Much has been written about the problems of the SSI sector in the Indian context. The growth of small scale industry in India, to a large extent is induced by the lack of alternative employment opportunities and promotional policies adopted by government (Desai, 1983)45. Due to lack of entrepreneurial attitude and proper training a large number of them have met with untimely closure. Some of the major problems can be identified as follows. Financial Constraints: Though there are a number of efforts to provide finances to the SSI units, the most needy ones do not get proper information about different schemes and often depend on the informal credit market for finance. Coming up with an appropriate proposal also becomes difficult for such small entrepreneurs. Access to raw materials is another problem faced by these units. One of the major handicaps of the small-scale sector has been the absence of improved technology, which alone can ensure quality and higher productivity. Technology is the most essential factor to remain competitive in a global market. Lack of information again plays a critical role in the choice of technology. Marketing remains the major stumbling block for the growth of SSI sector. Ignorance of potential markets, in particular, unfamiliarity with export activities contributes to this problem. Poor designing and finish also often makes the product not salable in the international market.

45

Desai. V, 1983, Problems and Prospects of Small Scale Industries in India, Himalaya

Publishing House, Bombay.

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As far as production methods are concerned there is often faulty planning and inadequate appraisal of projects (Desai, 1983). Most often no proper viability studies, technical or economic, are carried out.

Policy makers recognized these shortcomings and created a number of offices to handle the problems. However, proper implementation has never been accomplished. Consequently sickness remained a major problem for this sector. To understand the problems of the sector in general and concerning credit facilities in particular in a liberalized regime, a survey has been taken up. Though the survey has been conducted in three states of India viz., Karnataka, Kerala and West Bengal.

6.2 Sampling Technique

It is well recognized that industry sector is not forthcoming in providing information. This problem has noted down by many authors (see Deshpande et al, 2004)46. In this background we are forced to adopt snowball sampling technique. Industry Association gave contacts of the firms and requested them to cooperate with the survey. The firms that agreed for a discussion were later interviewed using structured questionnaires that were personally canvassed. The sample firms are from Kerala, Karnataka and West Bengal and the sample sizes from these locations are respectively 50, 100 and 50.

6.3 Characteristics of the Sampled Firms

One of the important findings of the survey is that 35% of the manufacturing firms in our sample are not availing loan from the institutional sources. These firms reported to manage their investments from their own (or borrowing from relatives) resources. Out of the rest 68% only 2% have availed loan from private banks. Thus dependency on public sector banks remains prevalent.

46

Deshpande, Lalit et al, 2004, Liberalization and Labour: Labour Flexibility in Indian Manufacturing, Institute of Human Development, New Delhi.

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While examining the investment in plant and machinery one observes that most of the firms included in the survey falls under the Government of India definition of SSI. Only about 2% of the firms have investment above Rs 1 crore. However as far as commercial banks are concerned, for credit purposes they combine small and medium firms together table 6.1).

Table 6.1.Total investment

Investment 10000 - 100000 100000 - 500000 500001 - 1000000 1000001 - 2500000 2500001 - 5000000 5000001 - 1 crore 10000001 - Above Total Percent 5 17.5 37.5 15 12.5 10 2.5 100

Average turnover is between 30 lakhs to 50 lakhs. Thus these are comparatively large sized firms within the SSI category (table 6.2).

Table 6.2. Total turnovers of the firms.

Turnover in Rs. 300000 - 1000000 1000001 - 3000000 3000001 - 5000000 5000001 - 7000000 7000001 - 1 crore 10000001 - Above Total This year 8 (20.00) 11 (27.50) 8 (20.00) 5 (12.50) 3 (7.50) 5 (12.50) 40 (100) Last year 9 (22.50) 12 (30.00) 8 (20.00) 2 (5.00) 3 (7.50) 5 (12.50) 40 (100) On an average 8 (20.00) 11 (27.50) 10 (25.00) 2 (5.00) 3 (7.50) 6 (15.00) 40 (100)

These firms are managed by qualifies entrepreneurs as can be seen from table 6.3. Above 50% of the firms owners are technical degree holders.

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Table 6.3 Educational qualifications of the firm manager and Owners.

Qualification 1 2 3 4 5 6 7 8 9 10 11 12 13 14 7th SSLC PUC BA Bcom Bsc MA(Eco) deploma(e,p.m.t.tex,) ITI BE Mtech MBBS MCA Total

Percent 3.39 15.25 5.08 1.69 6.78 6.78 1.69 22.03 1.69 27.12 5.08 1.69 1.69 100

Source: primary data

Source: Field Survey However, they have the typical characteristic of small firms with lesser number of workers. Table 6. 4 shows that almost half of firms have less than 10 workers.

Table 6.4 Total Employment positions of the firms. Total Employment employment 0-2 2.5 3-5 2.5 6-10 42.5 11-15 15 16-20 2.5 21-25 10 26-30 5.00 Total 100 Source: Field Survey

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These firms are mostly catering to the large firms within the state of Karnataka; as high as 87% of these firms have subcontracting relation with a firm in Karnataka itself. Only 13% of the firms are marketing their product independently. Out of the 87% of the firms 35% are also catering to firms outside Karnataka and 2.5% are engaged in exports as well (Table 6.5).

Table 6.5 Marketing of products. Large firm Market in the same state 87.5 Source: Filed Survey Large firm in the Export another state 35 2.5

6.4 Loan Amount and Rate of Interest: An Inverse Relation

One of the major objectives in this study is to examine the relation between the borrowings and the rate of interest charged by the banks. It is interesting to note that about 66% of the small borrowers (below Rs 50,000) pays interest rate of 17% or higher, whereas the large borrowers pay comparatively lower interest rate. The category of borrowers that borrows 40 lakhs or more pays interest rate below 12% (Table 6.6). This may be because banks find the small borrowers comparatively more risky. Banks fixes the rate of interest based on a number of criteria involving risky ness of a project, amount of collateral and past records. Small borrowers may have been in a disadvantageous position if they have started a new business with less collateral. The correlation between loan amount and rate of interest indeed shows a negative value 0.370, which is statistically significant at 5% level.

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Table 6.6 Percentage of firms cross tabulated with respect to Loan amount and rate of interest.

Bank rate of interest ( in Rs.) Total loan amount ( in Rs ) upto - 50000 Total 9 - 10 11 - 12 33.33 10 50 10 33.33 20 50 33.33 50 20 20 33.33 25 33.33 11.54 100 20 10 75 30 38.46 100 19.23 100 19.23 100 11.54 100 16.67 20 50 20 50 40 20 20 40 40 50 20 33.33 40 16.67 33.33 13 14 15 - 16 17 - 24 66.67 66.67 100 11.54 100 7.69 100 23.08 100 7.69 100 15.38 100 19.23 100 15.38462 100 100

50000 - 200000

200001 - 500000

500001 - 1000000

1000001 - 2000000

2000001 - 4000000

4000001 - above

Total

Source: Field Survey

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6.5 Problem of Bad Loans : Views of the Karnataka Firms

Only about 3% of the firms have admitted to be defaulter in our sample. The rest of the firms even though did not admit themselves to be defaulter have given possible reasons for default by the small firms. It is interesting to note that about 80 % of the firms consider excessive competition as a reason for low profit margin, which in turn affects repayment capability adversely. But interestingly only 76% felt that opening up of the market and competition from China is really not hampering small firms in our study area (Table 6.7). Problem of non repayment of loan arising mainly due to non repayment of dues by the large firms and large amount of rejection at a point of time. The former has been well recognized by RBI and now small firms can take actions against large firms in case of such defaults. However, as far as possible a small firm will not initiate such a process due to its high dependence on the large firm. The latter may arise due to increased quality concerns of the large firms. Our discussion with the bank officials also reveals that diversion of funds is another major reason for default.

Table 6.7 Reasons are default of the firms.

Reasons for default a) Diversion of funds b) Misunderstanding amongst partners. c) Too much competition in the market d) Huge quantity of finished product rejected e) Competition from China/other country due to opening the market. f) Large firms do not pay in time. g) Too much borrowing. h) Dependence on one or two large units i) Marketing problem Yes 53 42 80 75 24 75 51 64 53

Source: primary data

Problem of willful default is accepted to be present by all firms, though expectedly no one admitted to have adhered to such a practice. Diversion of funds has been the major reason for willful default. This has also been stated during our interactions with the bank officials. Entrepreneurs sometimes borrow in the name of a project but divert funds later for purposes that can give more returns than an SSI unit.

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Secondly, when a firm is running by a manger, the problem of principal agent and in turn monitoring exists. This sometime may result in default of loan as collateral belongs to the firm owner. It has been observed by 7% of the respondents that high influence such as political influence may result in willful default. This was also found to be true during our discussions with the bank officials. Borrowers having strong political connections often hold the view that they cannot be punished in any manner when they default. Another reason cited by the firm owners is pure negligence. This as well has been found to be true during our discussions with the bank officials. Even when business is running well some borrowers do not repay loans as they feel that bank can never take any stringent action. A few respondents also complained of collusive agreement between bank officials and borrowers, which lead to such mal practices (Table 6.8). Table 6.8 Opinions for the willful defaulted of firms.
Opinion a) Misuse of funds b) Technically not confident c) Managerial problem d) Subcontracting firms fault e) High influence f) Negligence g) Bankers corruption Yes 85 8 14 7 7 5 10

Source: primary data

It has been felt by the industry circle that taking prompt action and being more vigilant can control willful default (Table 6.9). Right now it takes on an average about 10 years to take control of the collateral/security. In the process plant and machinery depreciates considerably, the defaulter also get sufficient return from the diverted funds and bank becomes the major loser. SARFEISI act which ensures that a bank need not go through a regular process of litigations through courts , may help to some extent in this regard. In certain cases when default may be due to sheer negligence, serious advice from the bank officials are necessary. To do this effectively bank officials may be given more powers to take actions.

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Table 6.9 Opinion from respondents to avoid the bank willful default Avoid Opinion Seizing collateral Checking Self with athentification Counseling Yes 92.50 65 15 10

6.6 Problem of the Lending System

There are a number of problems faced by the borrowers from the SSI segment (Table 6.10). All the respondents considered procedures rather complicated, needing too many documentations. Number of times one needs to visit banks initially is as high as 10 to 20 times (Table 6.11). Table 6.10. Current problems exist with the lending system.

Current Problems Collateral problem Excess document/complicated procedure Not enough working capital loan High rate of interest

Yes 65 100 12.50 27.50

This needs to be noted in the background of education levels of the respondents. If such highly educated respondents find the process complicated one can easily imagine the plight of the uneducated ones. Above 50% of the respondents who have 320

taken loan needed to visit the respective banks a minimum of 8 to 10 times before getting the loan and about 12% visited between 11 to 30 times. After availing the loan on an average in six months they need to visit 8 to 10 times; another 22% visited the bank between 10 to 30 times. Interestingly, 5% needed to visit the bank about 50 times of more; which amounts to about 10 visits per month. This really adds to the transaction costs to the borrowers. Table 6.11 Number of times respondents need to visit banks. No of times 8- 10 11-30 31-50 51 Above No applied Initially go 52.5 12.5 0 0 35 In six month 30 22.5 7.5 5 35

Excess requirement of collateral is another major problem. Some banks demand three or four times higher value of security, personal guarantee and collaterals vis-a vis the loan amount. A small entrepreneur does not usually possess assets and needs to refrain from borrowing. Though rate of interest have come down to some extent small borrowers usually pay around 2 to 3% higher than the prime lending rate (PLR). However, what is to note is that, all borrowers are charged considerable amount by the banks for handling their accounts in addition to the rate of interest charged. These comprise of cheque leaf charges, currier charges, charges for returned chaques, charges for bank officers visits and so on. Our estimate from our survey reveals that of such additional charges amounts to an additional rate of interest of 6%. Thus, if for example, the charged rate of interest is 13%, the actual resource goes to the bank at the rate of about 18 to 19%. The 35 % of the firms that did not take loan from bank have used their own funds or from relatives to finance their business ventures. Maximum investment of these firms is Rs 10 lakhs. As far as reasons for not approaching banks are concerned 84% of them have noted excessive collateral requirement as crucial one. While complicated procedures have been noted by all, 15% also stated that working capital loan to be provided by the bank was so insufficient that they have decided not to approach banks.

Given this scenario naturally, maximum number of respondents voiced for hassle free lending mechanism (table 6.12). 10% have indicated that a separate cell for SSI lending may reduce some of the problems. 30% also feels that bank officials do not give equal treatment to all borrowers. Economically better off or politically linked borrowers

321

get priority. This can not only increase willful default but also induce good borrowers to move to informal sector even when faced with high interest rate. Table 6.12. Suggestions for lending system (banks) Percentage of respondents 77.50 10 30

Helpful changes Easy procedure Separate cell No corruption

6.7 Problem of Bad Loans: Views of the Firms from West Bengal

The firms from West Bengal, maily located in the capital city Kolkata, echoed the same views as that of their Karnataka counterpart. In our sample 100% of the respondents have taken loan from the public sector banks. According to them intense competition in the market is one reason for genuine default. Indeed, they have found the rate of return to be much lower and comparatively therefore interest rate very high. However, no firm has considered competition from outside firms such as that from China is responsible for this. Wrong planning in the form of too much borrowing and , marketing are also problems of genuine default (Table 6.14). Table 6.14 Reason for default of the firm Reason for default a) Diversion of funds
b) Misunderstanding amongst partners c) Too much competition in the market d) Huge quantity of finished product rejected e) Competition from china/other country

Percentage of firms say yes 23.8

4.8 23.8

322

due to opening the market f) Large firms do not pay in time g) Too much borrowing h) Dependence on one or two large units i) Marketing problem j) Any other Wastage problem High rate of interest Recession

23.8

14.3 4.8 4.8 4.8

As far as willful default is concerned respondents from Kolkata has not found bankers corruption as a possible reason. Rather respondents feel that misuse of funds and political influence of the borrowers often lead to such willful default (table 6.15). Table 6.15 Opinion about willful default Opinion Misuse/Diversion of fund
b) Technical incompetence c) Managerial problem

Yes 38.1
14.3 14.3

d) Unavoidable for small firms 9.5 e) High influence f) Negligence g) Bankers corruption 19.0

0 0

Source: Survey

Above 90% of the respondent firms voiced that prompt seizing of collateral is the most effective way to reduce such intentional default. As far as the problem of the current banking system is concerned one issue that came up again and again in the case of Kolkata firms is the rate of interest (Table 6.16). This may be due to the fact that in Kolkata there are large number of SSI firms that operate in lower segment of the market where competition is intense and price realization is less. Hence the rate of interest that the bank changes turns out to be high for them. Procedural complications remains a problem for the borrowers of all regions. Table 6.16 Currently any problem with the lending system Current problem Yes

323

b) Excess document c) Complicated procedure d) Discouraging behavior of other staff e) Not enough working capital loan f) High rate of interest

57.1 57.1

4.8 4.8 85.7

Source: Survey 6.8 Problem of Bad Loans: Views of the Firms from Kerala

Unlike the other two groups , Kerala firms consider all possible reasons as equally important in causing genuine default of the SSI firms. More importantly problem caused by the large firms and competition from inside as well as aboard are highlighted during our survey (Table 6.17). Table 6.17 Reason for default Reason for default a) Diversion of funds
b) Misunderstanding amongst partners c) Too much competition in the market d) Huge quantity of finished product rejected e) Competition from china/other country due to opening the market. f) Large firms do not pay in time g) Too much borrowing h) Dependence on one or two large units i) Marketing problem

Respondent Percentage 33.3 22.2 44.4 44.4 33.3 44.4 33.3 44.4 66.7

Source: Survey As far as willful default is concerned, in all regions politically influential borrowers tend to avoid repayment is a concern of all genuine borrowers. Corruption on the part of the bank officials has also been highlighted in Kerala as well as in Kranataka (Table 6.18). Table 6.18 Opinion about willful default Opinion Yes a) Miss use of fund 22.2 b) Managerial problem 55.6 c) High influence d) Negligence 22.2 66.7

324

e) Bankers corruption 44.4 Source: Survey Prompt seizing of the collateral is the most effective way of reducing such default. However, 11% of the respondent firms also felt that counseling by bank officials may help reducing default. Excessive documentation and complicated procedures appear to be the common problem felt by all borrowers across regions (Table 6.19). However, high rate of interest is also another major problem faced by the borrowers. It must be noted in this context that usually these borrowers do not receive any concessional rate and pay about 2 to 3 percent higher than the prime lending rate. More importantly a beginner often needs to pay higher rate of interest and our analysis shows that smaller the loan size is (which often implies smaller the size of the firm is) higher is the rate of interest. Table 6.19 Current problems in lending system Current Problem b) Excess document c) Complicated procedure d) High rate of interest Source: Survey Suggestions to the policy makers are many and found to be similar across regions (Table 6.20). Table 6.20 Suggestions to the policy makers Kind of Help Power rate should be low Pay in time Provide the subsidy Percent 33.3 11.1 11.1 66.7 Percent 33.3 44.4 a) Collateral problem 22.7

325

Reduce the sale tax Provide the employ ESI Provide the land Provide the power supply continuously

44.4 22.2 33.3 66.7

To train the projects guidance of the Bank manager 66.7 Provide the information about bank. Source: Source In the infrastructure front power is the major concern. Secondly the firms across regions want the bank manger to play a more active role rather than being just a fund provider. As mentioned above most of these firm owners possess technical knowledge but lacks management oriented knowledge of costing , pricing etc. This is the area where some help from the banking sector is sought. They are also aware that some capacity building for the bank officials may be necessary for them to provide effective support. A separate cell in the bank for the sector may be useful in this regard. Right now the Small Industries Development Bank is there to cater to this sector in a more involved manner. However, SIDBI office and few and far between and firms cannot avail their help as and when required. Thus active role needs to be played by the commercial banking sector. 66.7

6.9 Concluding Remarks

During our intensive discussions with the bank officials it has been revealed that the problem of NPA is reducing over time for the SSI sector. On the other hand it is becoming more prevent in the personal loan segment. From our secondary data analysis we have also seen that banks credit towards the SSI sector is also declining. Our interviews with the SSI entrepreneurs reveal that non-repayment is often genuine, that is, due to failure in the business. In the SSI segment competition is much more intense which results in stiff price competition. While some segments do face competition from cheap Chinese products, our respondents did not feel that globalization has made the situation worse. The small firm owners during our survey have suggested several

326

initiatives from the policy makers which may be helpful for the sector. One of the major problem the sector faces is the quality power supply. Such infrastructure bottlenecks need to be handled to improve productivity. Globalization indeed has helped some of the large firms to export and in turn increased subcontracting business for the small firms; the growing automobile sector is a case in point here. Exporting firms or multinationals however are quite quality conscious and not meeting their requirements and resulting large scale rejection of products often put small firms in the verge of bankruptcy. Non-repayment of dues by the large firms on time also is a serious concern, which has been well recognized in the literature. These are some of the genuine reasons for business failure and resulting default. Some of these can be avoided through proper planning. Bank as a lender can act as a partner of an SSI unit than as a policeman. For example, many SSI units we interviewed admitted that they have technological knowledge but lack expertise on management aspects. Thus costing and pricing strategies are adhoc and faulty. Neither do they have sufficient resources to engage professionals. The firm owners felt that training of bank officials is necessary for them to impart knowledge and act as a partner. In this regard State Bank of India, stressed asset and rehabilitation cell have been advising some of the defaulters on these aspects. More such efforts should come from the banks. The case of willful default however, needs to be taken rather seriously. Currently, banks do not identify any defaulter as a willful defaulter. Thus there is no difference in terms of actions taken by the bank between a genuine and a willful defaulter. This approach should change. Making a confidential list of willful defaulters may deter these borrowers to engage in such activities. Right now a defaulter can indeed go to another bank for a fresh loan and this often goes unnoticed. More vigilance and prompt action is the need of the hour rather than avoiding the small borrowers.

327

CHAPTER 6 Problem of Loan Repayment: Views of the SSI Units

6.1 Introduction

Much has been written about the problems of the SSI sector in the Indian context. The growth of small scale industry in India, to a large extent is induced by the lack of alternative employment opportunities and promotional policies adopted by government (Desai, 1983)47. Due to lack of entrepreneurial attitude and proper training a large number of them have met with untimely closure. Some of the major problems can be identified as follows. Financial Constraints: Though there are a number of efforts to provide finances to the SSI units, the most needy ones do not get proper information about different schemes and often depend on the informal credit market for finance. Coming up with an appropriate proposal also becomes difficult for such small entrepreneurs. Access to raw materials is another problem faced by these units. One of the major handicaps of the small-scale sector has been the absence of improved technology, which alone can ensure quality and higher productivity. Technology is the most essential factor to remain competitive in a global market. Lack of information again plays a critical role in the choice of technology. Marketing remains the major stumbling block for the growth of SSI sector. Ignorance of potential markets, in particular, unfamiliarity with export activities contributes to this problem. Poor designing and finish also often makes the product not salable in the international market.

47

Desai. V, 1983, Problems and Prospects of Small Scale Industries in India, Himalaya

Publishing House, Bombay.

328

As far as production methods are concerned there is often faulty planning and inadequate appraisal of projects (Desai, 1983). Most often no proper viability studies, technical or economic, are carried out.

Policy makers recognized these shortcomings and created a number of offices to handle the problems. However, proper implementation has never been accomplished. Consequently sickness remained a major problem for this sector. To understand the problems of the sector in general and concerning credit facilities in particular in a liberalized regime, a survey has been taken up. Though the survey has been conducted in three states of India viz., Karnataka, Kerala and West Bengal.

6.2 Sampling Technique

It is well recognized that industry sector is not forthcoming in providing information. This problem has noted down by many authors (see Deshpande et al, 2004)48. In this background we are forced to adopt snowball sampling technique. Industry Association gave contacts of the firms and requested them to cooperate with the survey. The firms that agreed for a discussion were later interviewed using structured questionnaires that were personally canvassed. The sample firms are from Kerala, Karnataka and West Bengal and the sample sizes from these locations are respectively 50, 100 and 50.

6.3 Characteristics of the Sampled Firms

One of the important findings of the survey is that 35% of the manufacturing firms in our sample are not availing loan from the institutional sources. These firms reported to manage their investments from their own (or borrowing from relatives) resources. Out of the rest 68% only 2% have availed loan from private banks. Thus dependency on public sector banks remains prevalent.

48

Deshpande, Lalit et al, 2004, Liberalization and Labour: Labour Flexibility in Indian Manufacturing, Institute of Human Development, New Delhi.

329

While examining the investment in plant and machinery one observes that most of the firms included in the survey falls under the Government of India definition of SSI. Only about 2% of the firms have investment above Rs 1 crore. However as far as commercial banks are concerned, for credit purposes they combine small and medium firms together table 6.1).

Table 6.1.Total investment

Investment 10000 - 100000 100000 - 500000 500001 - 1000000 1000001 - 2500000 2500001 - 5000000 5000001 - 1 crore 10000001 - Above Total Percent 5 17.5 37.5 15 12.5 10 2.5 100

Average turnover is between 30 lakhs to 50 lakhs. Thus these are comparatively large sized firms within the SSI category (table 6.2).

Table 6.2. Total turnovers of the firms.

Turnover in Rs. 300000 - 1000000 1000001 - 3000000 3000001 - 5000000 5000001 - 7000000 7000001 - 1 crore 10000001 - Above Total This year 8 (20.00) 11 (27.50) 8 (20.00) 5 (12.50) 3 (7.50) 5 (12.50) 40 (100) Last year 9 (22.50) 12 (30.00) 8 (20.00) 2 (5.00) 3 (7.50) 5 (12.50) 40 (100) On an average 8 (20.00) 11 (27.50) 10 (25.00) 2 (5.00) 3 (7.50) 6 (15.00) 40 (100)

These firms are managed by qualifies entrepreneurs as can be seen from table 6.3. Above 50% of the firms owners are technical degree holders.

330

Table 6.3 Educational qualifications of the firm manager and Owners.

Qualification 1 2 3 4 5 6 7 8 9 10 11 12 13 14 7th SSLC PUC BA Bcom Bsc MA(Eco) deploma(e,p.m.t.tex,) ITI BE Mtech MBBS MCA Total

Percent 3.39 15.25 5.08 1.69 6.78 6.78 1.69 22.03 1.69 27.12 5.08 1.69 1.69 100

Source: primary data

Source: Field Survey However, they have the typical characteristic of small firms with lesser number of workers. Table 6. 4 shows that almost half of firms have less than 10 workers.

Table 6.4 Total Employment positions of the firms. Total Employment employment 0-2 2.5 3-5 2.5 6-10 42.5 11-15 15 16-20 2.5 21-25 10 26-30 5.00 Total 100 Source: Field Survey

331

These firms are mostly catering to the large firms within the state of Karnataka; as high as 87% of these firms have subcontracting relation with a firm in Karnataka itself. Only 13% of the firms are marketing their product independently. Out of the 87% of the firms 35% are also catering to firms outside Karnataka and 2.5% are engaged in exports as well (Table 6.5).

Table 6.5 Marketing of products. Large firm Market in the same state 87.5 Source: Filed Survey Large firm in the Export another state 35 2.5

6.4 Loan Amount and Rate of Interest: An Inverse Relation

One of the major objectives in this study is to examine the relation between the borrowings and the rate of interest charged by the banks. It is interesting to note that about 66% of the small borrowers (below Rs 50,000) pays interest rate of 17% or higher, whereas the large borrowers pay comparatively lower interest rate. The category of borrowers that borrows 40 lakhs or more pays interest rate below 12% (Table 6.6). This may be because banks find the small borrowers comparatively more risky. Banks fixes the rate of interest based on a number of criteria involving risky ness of a project, amount of collateral and past records. Small borrowers may have been in a disadvantageous position if they have started a new business with less collateral. The correlation between loan amount and rate of interest indeed shows a negative value 0.370, which is statistically significant at 5% level.

332

Table 6.6 Percentage of firms cross tabulated with respect to Loan amount and rate of interest.

Bank rate of interest ( in Rs.) Total loan amount ( in Rs ) upto - 50000 Total 9 - 10 11 - 12 33.33 10 50 10 33.33 20 50 33.33 50 20 20 33.33 25 33.33 11.54 100 20 10 75 30 38.46 100 19.23 100 19.23 100 11.54 100 16.67 20 50 20 50 40 20 20 40 40 50 20 33.33 40 16.67 33.33 13 14 15 - 16 17 - 24 66.67 66.67 100 11.54 100 7.69 100 23.08 100 7.69 100 15.38 100 19.23 100 15.38462 100 100

50000 - 200000

200001 - 500000

500001 - 1000000

1000001 - 2000000

2000001 - 4000000

4000001 - above

Total

Source: Field Survey

333

6.5 Problem of Bad Loans : Views of the Karnataka Firms

Only about 3% of the firms have admitted to be defaulter in our sample. The rest of the firms even though did not admit themselves to be defaulter have given possible reasons for default by the small firms. It is interesting to note that about 80 % of the firms consider excessive competition as a reason for low profit margin, which in turn affects repayment capability adversely. But interestingly only 76% felt that opening up of the market and competition from China is really not hampering small firms in our study area (Table 6.7). Problem of non repayment of loan arising mainly due to non repayment of dues by the large firms and large amount of rejection at a point of time. The former has been well recognized by RBI and now small firms can take actions against large firms in case of such defaults. However, as far as possible a small firm will not initiate such a process due to its high dependence on the large firm. The latter may arise due to increased quality concerns of the large firms. Our discussion with the bank officials also reveals that diversion of funds is another major reason for default.

Table 6.7 Reasons are default of the firms.

Reasons for default a) Diversion of funds b) Misunderstanding amongst partners. c) Too much competition in the market d) Huge quantity of finished product rejected e) Competition from China/other country due to opening the market. f) Large firms do not pay in time. g) Too much borrowing. h) Dependence on one or two large units i) Marketing problem Yes 53 42 80 75 24 75 51 64 53

Source: primary data

Problem of willful default is accepted to be present by all firms, though expectedly no one admitted to have adhered to such a practice. Diversion of funds has been the major reason for willful default. This has also been stated during our interactions with the bank officials. Entrepreneurs sometimes borrow in the name of a project but divert funds later for purposes that can give more returns than an SSI unit.

334

Secondly, when a firm is running by a manger, the problem of principal agent and in turn monitoring exists. This sometime may result in default of loan as collateral belongs to the firm owner. It has been observed by 7% of the respondents that high influence such as political influence may result in willful default. This was also found to be true during our discussions with the bank officials. Borrowers having strong political connections often hold the view that they cannot be punished in any manner when they default. Another reason cited by the firm owners is pure negligence. This as well has been found to be true during our discussions with the bank officials. Even when business is running well some borrowers do not repay loans as they feel that bank can never take any stringent action. A few respondents also complained of collusive agreement between bank officials and borrowers, which lead to such mal practices (Table 6.8). Table 6.8 Opinions for the willful defaulted of firms.
Opinion a) Misuse of funds b) Technically not confident c) Managerial problem d) Subcontracting firms fault e) High influence f) Negligence g) Bankers corruption Yes 85 8 14 7 7 5 10

Source: primary data

It has been felt by the industry circle that taking prompt action and being more vigilant can control willful default (Table 6.9). Right now it takes on an average about 10 years to take control of the collateral/security. In the process plant and machinery depreciates considerably, the defaulter also get sufficient return from the diverted funds and bank becomes the major loser. SARFEISI act which ensures that a bank need not go through a regular process of litigations through courts , may help to some extent in this regard. In certain cases when default may be due to sheer negligence, serious advice from the bank officials are necessary. To do this effectively bank officials may be given more powers to take actions.

335

Table 6.9 Opinion from respondents to avoid the bank willful default Avoid Opinion Seizing collateral Checking Self with athentification Counseling Yes 92.50 65 15 10

6.6 Problem of the Lending System

There are a number of problems faced by the borrowers from the SSI segment (Table 6.10). All the respondents considered procedures rather complicated, needing too many documentations. Number of times one needs to visit banks initially is as high as 10 to 20 times (Table 6.11). Table 6.10. Current problems exist with the lending system.

Current Problems Collateral problem Excess document/complicated procedure Not enough working capital loan High rate of interest

Yes 65 100 12.50 27.50

This needs to be noted in the background of education levels of the respondents. If such highly educated respondents find the process complicated one can easily imagine the plight of the uneducated ones. Above 50% of the respondents who have 336

taken loan needed to visit the respective banks a minimum of 8 to 10 times before getting the loan and about 12% visited between 11 to 30 times. After availing the loan on an average in six months they need to visit 8 to 10 times; another 22% visited the bank between 10 to 30 times. Interestingly, 5% needed to visit the bank about 50 times of more; which amounts to about 10 visits per month. This really adds to the transaction costs to the borrowers. Table 6.11 Number of times respondents need to visit banks. No of times 8- 10 11-30 31-50 51 Above No applied Initially go 52.5 12.5 0 0 35 In six month 30 22.5 7.5 5 35

Excess requirement of collateral is another major problem. Some banks demand three or four times higher value of security, personal guarantee and collaterals vis-a vis the loan amount. A small entrepreneur does not usually possess assets and needs to refrain from borrowing. Though rate of interest have come down to some extent small borrowers usually pay around 2 to 3% higher than the prime lending rate (PLR). However, what is to note is that, all borrowers are charged considerable amount by the banks for handling their accounts in addition to the rate of interest charged. These comprise of cheque leaf charges, currier charges, charges for returned chaques, charges for bank officers visits and so on. Our estimate from our survey reveals that of such additional charges amounts to an additional rate of interest of 6%. Thus, if for example, the charged rate of interest is 13%, the actual resource goes to the bank at the rate of about 18 to 19%. The 35 % of the firms that did not take loan from bank have used their own funds or from relatives to finance their business ventures. Maximum investment of these firms is Rs 10 lakhs. As far as reasons for not approaching banks are concerned 84% of them have noted excessive collateral requirement as crucial one. While complicated procedures have been noted by all, 15% also stated that working capital loan to be provided by the bank was so insufficient that they have decided not to approach banks.

Given this scenario naturally, maximum number of respondents voiced for hassle free lending mechanism (table 6.12). 10% have indicated that a separate cell for SSI lending may reduce some of the problems. 30% also feels that bank officials do not give equal treatment to all borrowers. Economically better off or politically linked borrowers

337

get priority. This can not only increase willful default but also induce good borrowers to move to informal sector even when faced with high interest rate. Table 6.12. Suggestions for lending system (banks) Percentage of respondents 77.50 10 30

Helpful changes Easy procedure Separate cell No corruption

6.7 Problem of Bad Loans: Views of the Firms from West Bengal

The firms from West Bengal, maily located in the capital city Kolkata, echoed the same views as that of their Karnataka counterpart. In our sample 100% of the respondents have taken loan from the public sector banks. According to them intense competition in the market is one reason for genuine default. Indeed, they have found the rate of return to be much lower and comparatively therefore interest rate very high. However, no firm has considered competition from outside firms such as that from China is responsible for this. Wrong planning in the form of too much borrowing and , marketing are also problems of genuine default (Table 6.14). Table 6.14 Reason for default of the firm Reason for default a) Diversion of funds
b) Misunderstanding amongst partners c) Too much competition in the market d) Huge quantity of finished product rejected e) Competition from china/other country

Percentage of firms say yes 23.8

4.8 23.8

338

due to opening the market f) Large firms do not pay in time g) Too much borrowing h) Dependence on one or two large units i) Marketing problem j) Any other Wastage problem High rate of interest Recession

23.8

14.3 4.8 4.8 4.8

As far as willful default is concerned respondents from Kolkata has not found bankers corruption as a possible reason. Rather respondents feel that misuse of funds and political influence of the borrowers often lead to such willful default (table 6.15). Table 6.15 Opinion about willful default Opinion Misuse/Diversion of fund
b) Technical incompetence c) Managerial problem

Yes 38.1
14.3 14.3

d) Unavoidable for small firms 9.5 e) High influence f) Negligence g) Bankers corruption 19.0

0 0

Source: Survey

Above 90% of the respondent firms voiced that prompt seizing of collateral is the most effective way to reduce such intentional default. As far as the problem of the current banking system is concerned one issue that came up again and again in the case of Kolkata firms is the rate of interest (Table 6.16). This may be due to the fact that in Kolkata there are large number of SSI firms that operate in lower segment of the market where competition is intense and price realization is less. Hence the rate of interest that the bank changes turns out to be high for them. Procedural complications remains a problem for the borrowers of all regions. Table 6.16 Currently any problem with the lending system Current problem Yes

339

b) Excess document c) Complicated procedure d) Discouraging behavior of other staff e) Not enough working capital loan f) High rate of interest

57.1 57.1

4.8 4.8 85.7

Source: Survey 6.8 Problem of Bad Loans: Views of the Firms from Kerala

Unlike the other two groups , Kerala firms consider all possible reasons as equally important in causing genuine default of the SSI firms. More importantly problem caused by the large firms and competition from inside as well as aboard are highlighted during our survey (Table 6.17). Table 6.17 Reason for default Reason for default a) Diversion of funds
b) Misunderstanding amongst partners c) Too much competition in the market d) Huge quantity of finished product rejected e) Competition from china/other country due to opening the market. f) Large firms do not pay in time g) Too much borrowing h) Dependence on one or two large units i) Marketing problem

Respondent Percentage 33.3 22.2 44.4 44.4 33.3 44.4 33.3 44.4 66.7

Source: Survey As far as willful default is concerned, in all regions politically influential borrowers tend to avoid repayment is a concern of all genuine borrowers. Corruption on the part of the bank officials has also been highlighted in Kerala as well as in Kranataka (Table 6.18). Table 6.18 Opinion about willful default Opinion Yes a) Miss use of fund 22.2 b) Managerial problem 55.6 c) High influence d) Negligence 22.2 66.7

340

e) Bankers corruption 44.4 Source: Survey Prompt seizing of the collateral is the most effective way of reducing such default. However, 11% of the respondent firms also felt that counseling by bank officials may help reducing default. Excessive documentation and complicated procedures appear to be the common problem felt by all borrowers across regions (Table 6.19). However, high rate of interest is also another major problem faced by the borrowers. It must be noted in this context that usually these borrowers do not receive any concessional rate and pay about 2 to 3 percent higher than the prime lending rate. More importantly a beginner often needs to pay higher rate of interest and our analysis shows that smaller the loan size is (which often implies smaller the size of the firm is) higher is the rate of interest. Table 6.19 Current problems in lending system Current Problem b) Excess document c) Complicated procedure d) High rate of interest Source: Survey Suggestions to the policy makers are many and found to be similar across regions (Table 6.20). Table 6.20 Suggestions to the policy makers Kind of Help Power rate should be low Pay in time Provide the subsidy Percent 33.3 11.1 11.1 66.7 Percent 33.3 44.4 a) Collateral problem 22.7

341

Reduce the sale tax Provide the employ ESI Provide the land Provide the power supply continuously

44.4 22.2 33.3 66.7

To train the projects guidance of the Bank manager 66.7 Provide the information about bank. Source: Source In the infrastructure front power is the major concern. Secondly the firms across regions want the bank manger to play a more active role rather than being just a fund provider. As mentioned above most of these firm owners possess technical knowledge but lacks management oriented knowledge of costing , pricing etc. This is the area where some help from the banking sector is sought. They are also aware that some capacity building for the bank officials may be necessary for them to provide effective support. A separate cell in the bank for the sector may be useful in this regard. Right now the Small Industries Development Bank is there to cater to this sector in a more involved manner. However, SIDBI office and few and far between and firms cannot avail their help as and when required. Thus active role needs to be played by the commercial banking sector. 66.7

6.9 Concluding Remarks

During our intensive discussions with the bank officials it has been revealed that the problem of NPA is reducing over time for the SSI sector. On the other hand it is becoming more prevent in the personal loan segment. From our secondary data analysis we have also seen that banks credit towards the SSI sector is also declining. Our interviews with the SSI entrepreneurs reveal that non-repayment is often genuine, that is, due to failure in the business. In the SSI segment competition is much more intense which results in stiff price competition. While some segments do face competition from cheap Chinese products, our respondents did not feel that globalization has made the situation worse. The small firm owners during our survey have suggested several

342

initiatives from the policy makers which may be helpful for the sector. One of the major problem the sector faces is the quality power supply. Such infrastructure bottlenecks need to be handled to improve productivity. Globalization indeed has helped some of the large firms to export and in turn increased subcontracting business for the small firms; the growing automobile sector is a case in point here. Exporting firms or multinationals however are quite quality conscious and not meeting their requirements and resulting large scale rejection of products often put small firms in the verge of bankruptcy. Non-repayment of dues by the large firms on time also is a serious concern, which has been well recognized in the literature. These are some of the genuine reasons for business failure and resulting default. Some of these can be avoided through proper planning. Bank as a lender can act as a partner of an SSI unit than as a policeman. For example, many SSI units we interviewed admitted that they have technological knowledge but lack expertise on management aspects. Thus costing and pricing strategies are adhoc and faulty. Neither do they have sufficient resources to engage professionals. The firm owners felt that training of bank officials is necessary for them to impart knowledge and act as a partner. In this regard State Bank of India, stressed asset and rehabilitation cell have been advising some of the defaulters on these aspects. More such efforts should come from the banks. The case of willful default however, needs to be taken rather seriously. Currently, banks do not identify any defaulter as a willful defaulter. Thus there is no difference in terms of actions taken by the bank between a genuine and a willful defaulter. This approach should change. Making a confidential list of willful defaulters may deter these borrowers to engage in such activities. Right now a defaulter can indeed go to another bank for a fresh loan and this often goes unnoticed. More vigilance and prompt action is the need of the hour rather than avoiding the small borrowers.

343

CHAPTER 7 Non-performing Asset from the Perspectives of Commercial Banks

7.1 Introduction

In the previous chapter we have discussed the views of one set of stakeholders viz., the firm owners. The survey of the small firm entrepreneurs has no doubt brought out important issues concerning non-repayment of loan and willful default. It has also gone to the root causes of genuine default, which need to be addressed not only by the banks but also by the policy makers at large. To get a balanced view of any situation looking at both sides is necessary. In this case the other stakeholder is the commercial bank that advances the resources mobilized by them to the small firm entrepreneurs. Our discussions with the bank officials reveal that bad loans from the SSI sectors are indeed in decline. This is mainly due to the pressure on the bank officials to reduce over all NPA levels.

7.2 Approach to Information

In order to understand the views of the banks, we have had discussions with several bank officials who are in charge of the credit section. In particular, we have covered State Bank of India, State Bank of Travancore, Syndicate Bank, Canara Bank and others. We have also collected information about SSI accounts both pertaining to NPA as well as non-NPA accounts from the banks. For comparison purposes we have collected information about personal loan accounts as well. Information on individual accounts is a confidential matter and keeping this in mind banks has not revealed to us the identity of the borrowers. Data collection is organized as follows. To collect data from a particular bank, permission from the head office has been sought. After acquiring permissions, which indeed took considerable time, head offices identified certain branches and we

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have personally visited those branches for data collection49. Information on a sample of 200 accounts has been collected from different banks taken together. Another problem has been encountered with respect to the manner in which data are preserved by the banks. Different banks or even branches of a bank do not keep data in a uniform manner. Further, Companies though provide data on their turnover, profit and other financial variables to the banks a careful scrutiny revealed that these figures are not reliable. The reliable figures one can get are on loan amount, rate of interest, value of security/collateral, type of account (term loan or working capital loan), activity of the unit. 7.3 An Over all Picture from State Bank of Travancore (SBT) A disaggregated picture of NPA for small and medium enterprises at the bank level is not generally available. However, to understand the problem better we spent considerable time at the head office of SBT to get a sector-wise desegregation of bad loans. SBT has about 750 branches all over India but its main concentration is in the state of Kerala with 500 branches. Table 7.1 shows the extent of bad loans across different sectors.

Table 7.1 Industry-wise classifications of sick units and NPA

Industry No. Of Units % Of total sick units Engineering Electrical Textile 105 72 75 6.46 4.43 4.61 Outstanding (Rs crores) 6.12 3.53 5.62 % To total outstanding 8.05 4.64 7.39

Since these files are confidential they cannot be taken out or photocopied; bank officials also burdened with many responsibilities do no like to entertain such additional work during office hours. This made the data collection a rather slow process. While this process is currently going on, the present chapter makes a preliminary analysis of 200 SSI accounts.

49

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Paper and paper products Rubber and rubber products Chemical, dyes, paints Metal and Metal products Vegetable oils and vanaspati Food processing and producing Plastics Bricks Coir Bamboo Wood Readymade garments Miscellaneous Total

18

1.11

1.31

35

2.15

5.12

6.74

30

1.85

1.75

2.3

83

5.1

5.27

6.94

32

1.97

0.62

0.82

60

3.69

1.67

2.2

3 204 55 10 69 43

0.18 12.55 3.38 0.62 4.24 2.64

0.8 1 1.49 0.53 4.01 1.62

1.05 1.32 1.96 0.7 5.28 2.13

669 1626

41.15 100

33.26 75.99

43.77 100

Source: State Bank of Travancore, Head Office From the above information we observe that the miscellaneous category comprising various different manufacturing items such as bus seat cover, glass making and so on has

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the highest share in total number of sick units which also gives NPA accounts from SME segment. Industry-wise brick making industry appears to have large number of sick units even though amount involved is not comparatively higher. The reason for this industry to do poorly is the environmental norms imposed on it. Due to digging of soil the wells in the vicinity of the brick making unit go dry. Due to this reason several restrictions have been imposed on this segment that effected their normal functioning. Thus the discussions on SSI segment in the previous Chapter and the record of the banks indicate that reasons of sickness are many. NPA accounts are mainly due to prevalence of such sick units.
7.4 Important Observations

In the case of SME loan, the problem of genuine default is more common in nature compared to willful default. A specific example will reveal the situation. In SBT main branch office, out of a total of 130 SME accounts, 18 are NPA (i.e., 13%). Out of these 18, the concerned officials feel that maximum 5 (28%) may be willful50. The genuine reasons of default are more or less same as the reasons for sickness of the small units. According to the assessment of the banks a small entrepreneur does not have the necessary skill to arrive at proper estimates of costs, prices etc. In order to acquire a loan, they usually hire an accountant who comes up with figures in the proposal, which are later found to be unrealistic. Further, once an account becomes somewhat irregular banks take prompt action due to the pressure on them to reduce NPA levels. They curtail their funding to the unit concerned, which in turn makes the situation worse for the small firm.

In the case of personal loan however, default is much higher. Personal loan is given against salary certificates and collateral security is not necessary to avail them. Corporate employees in the big cities often avail such loans and shift cities for new jobs. It then becomes difficult for banks to trace them and retrieve loans. We observed several such

50

Due to the lack of concrete evidences, officially no account has been marked as willfully defaulted.

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cases during our survey. Loans to purchase durables also tend to become NPA more often.

As far as willful default is concerned no bank usually designates a borrower as willful defaulter. However, bank officials from their field visits can assess the cases. From our discussions with the bank officials it is observed that one can classify them into 3 categories: (1) People with political influence (2) Negligent borrowers who feel (for some reason or other) that they need not repay. This usually happens when they get loan under certain government scheme (during our survey this is observed in the case of SC/ST borrowers, women getting loan under special schemes)), (3) Borrowers who divert funds for other purposes. Some borrowers rightly understand that they can earn higher return by diverting their funds to other businesses such as real estate. By the time bank confiscate their security, which usually takes considerable time (8 to 10 years), they would earn much higher return than the lost security.

During our survey one category of willful defaulters have been found which needs to be dealt with strictly. These borrowers usually get loan under a well-planned government scheme introduced to help a weaker section such as women or other backward sections. There is a well organized intermediary network prevails which in collusion with the potential borrowers (such as poor women) prepare documents to avail loan for certain income generating purposes as per allowed by the policy. However, rather than investing it in the stated purpose both parties share the loan amount and in turn mis-utilize it. A banks has even given loan in a draft form in the name of the party that was supposed to supply the capital good to the borrower. This intermediary net-work is so effective that it establishes collusive agreements with the machine suppliers as well.

While only a small proportion of firms are willful defaulter, from a banks perspective this category assumes importance. While reducing the sickness of the SSI sector need not necessarily fall under the purview of the banking sector, combating the problem of willful

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default is a concern of the banking sector. Observing this RBI has of late came up with a number of measures to fight this problem.

7.4 Measures to Contain Wilful Default51

In order to disseminate information about wilful default, under the directive of RBI a scheme was framed under which the banks and notified All India Financial Institutions were required to submit to RBI the details of the willful defaulters. Wilful default broadly covered the following: a) Deliberate non-payment of the dues despite adequate cash flow and good net worth; b) Siphoning off of funds to the detriment of the defaulting unit; c) Assets financed either not been purchased or been sold and proceeds have misutilised; d) Misrepresentation / falsification of records; e) Disposal / removal of securities without bank's knowledge; f) Fraudulent transactions by the borrower. The above scheme came into force with effect from 1st April, 1999. Accordingly, banks and FIs started reporting certain cases of wilful defaults, which occurred or were detected after 31st March, 1999 on a quarterly basis. It covered all non-performing borrowers accounts with outstanding aggregating Rs.25 lakhs and above identified as willful default by a Committee of higher functionaries headed by the Executive Director and consisting of two GMs/DGMs. Banks/FIs were advised that they should examine all cases of wilful defaults of Rs 1.00 crore and above for filing of suits and also consider criminal action
Master Circular on Willful Defaulter, RBI/2006-07/35 DBOD No.DL.BC.19 /20.16.003/2006-07
51

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wherever instances of cheating/fraud by the defaulting borrowers were detected. In case of consortium/multiple lending, banks and FIs were advised that they report wilful defaults to other participating/financing banks also. Cases of wilful defaults at overseas branches were required be reported if such disclosure is permitted under the laws of the host country. The above scheme was in addition to the Scheme of Disclosure of Information on Defaulting Borrowers of banks and FIs introduced in April 1994; vide RBI Circular DBOD.No.BC/CIS/47/20.16.002/94 dated 23 April 1994. Guidelines issued on wilful defaulters (May 30, 2002) Considering the concerns expressed over the persistence of wilful default in the financial system in the 8th Report of the Parliament's Standing Committee on Finance on Financial Institutions, the Reserve Bank of India, in consultation with the Government of India, constituted in May 2001 a Working Group on Wilful Defaulters (WGWD) under the Chairmanship of Shri S. S. Kohli, the then Chairman of the Indian Banks' Association, for examining some of the recommendations of the Committee. The Group submitted its report in November 2001. An In-House Working Group constituted by the Reserve Bank further examined the recommendations of the WGWD. Accordingly, the banks/FIs were advised on May 30, 2002 for implementation, with immediate effect. Definition of wilful default As per the definition of RBI a "wilful default" would be deemed to have occurred if any of the following events is noted: (a) The unit has defaulted in meeting its payment / repayment obligations to the lender even when it has the capacity to honour the said obligations. (b) The unit has defaulted in meeting its payment / repayment obligations to the lender and has not utilised the finance from the lender for the specific purposes for which finance was availed of but has diverted the funds for other purposes. (c) The unit has defaulted in meeting its payment / repayment obligations to the lender and has siphoned off the funds so that the funds have not been utilised for 350

the specific purpose for which finance was availed of, nor are the funds available with the unit in the form of other assets."

Diversion and siphoning of funds

The terms diversion of funds and siphoning of funds should construe to mean the following:Diversion of funds, would be construed to include any one of the undernoted occurrences: (a) utilisation of short-term working capital funds for long-term purposes not in conformity with the terms of sanction; (b) deploying borrowed funds for purposes / activities or creation of assets other than those for which the loan was sanctioned; (c) transferring funds to the subsidiaries / Group companies or other corporates by whatever modalities; (d) routing of funds through any bank other than the lender bank or members of consortium without prior permission of the lender; (e) investment in other companies by way of acquiring equities / debt instruments without approval of lenders; (f) Shortfall in deployment of funds vis--vis the amounts disbursed / drawn and the difference not being accounted for. Siphoning of funds should be construed to occur if any funds borrowed from banks / FIs are utilised for purposes un-related to the operations of the borrower, to the detriment of the financial health of the entity or of the lender. The decision as to whether a particular instance amounts to siphoning of funds would have to be a judgement of the lenders based on objective facts and circumstances of the case.

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The identification of the wilful default should be made keeping in view the track record of the borrowers and should not be decided on the basis of isolated transactions/incidents. The default to be categorised as wilful must be intentional, deliberate and calculated.

End-use of Funds
In cases of project financing, the banks / FIs seek to ensure end-use of funds by, inter alia, obtaining certification from the Chartered Accountants for the purpose. In case of short-term corporate / clean loans, such an approach ought to be supplemented by 'due diligence' on the part of lenders themselves, and to the extent possible, such loans should be limited to only those borrowers whose integrity and reliability are above board. The banks and FIs, therefore, should not depend entirely on the certificates issued by the Chartered Accountants but strengthen their internal controls and the credit risk management system to enhance the quality of their loan portfolio. Needless to say, ensuring end-use of funds by the banks and the FIs should form a part of their loan policy document for which appropriate measures should be put in place. The following are some of the illustrative measures that could be taken by the lenders for monitoring and ensuring end-use of funds: (a) Meaningful scrutiny of quarterly progress reports / operating statements / balance sheets of the borrowers; (b) Regular inspection of borrowers assets charged to the lenders as security; (c) Periodical scrutiny of borrowers books of accounts and the no-lien accounts maintained with other banks; (d) Periodical visits to the assisted units; (e) System of periodical stock audit, in case of working capital finance;

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(f) Periodical comprehensive management audit of the Credit function of the lenders, so as to identify the systemic-weaknesses in the creditadministration. (It may be kept in mind that this list of measures is only illustrative and by no means exhaustive.)

Penal measures
In order to prevent the access to the capital markets by the wilful defaulters, a copy of the list of wilful defaulters (non-suit filed accounts) and (suit-filed accounts) are forwarded to SEBI by RBI and Credit Information Bureau (India) Ltd. (CIBIL) respectively. The following measures initiated by the banks and FIs against the wilful defaulters identified as per the definition indicated at paragraph 2.1 above: a) No additional facilities should be granted by any bank / FI to the listed wilful defaulters. In addition, the entrepreneurs / promoters of companies where banks / FIs have identified siphoning / diversion of funds, misrepresentation, falsification of accounts and fraudulent transactions should be debarred from institutional finance from the scheduled commercial banks, Development Financial Institutions, Government owned NBFCs, investment institutions etc. for floating new ventures for a period of 5 years from the date the name of the wilful defaulter is published in the list of wilful defaulters by the RBI. b) The legal process, wherever warranted, against the borrowers / guarantors and foreclosure of recovery of dues should be initiated expeditiously. The lenders may initiate criminal proceedings against wilful defaulters, wherever necessary. c) Wherever possible, the banks and FIs should adopt a proactive approach for a change of management of the wilfully defaulting borrower unit. d) A covenant in the loan agreements, with the companies in which the banks / notified FIs have significant stake, should be incorporated by the banks / FIs to 353

the effect that the borrowing company should not induct a person who is a promoter or director on the Board of a company which has been identified as a wilful defaulter as per the definition at paragraph 2.1 above and that in case, such a person is found to be on the Board of the borrower company, it would take expeditious and effective steps for removal of the person from its Board. It would be imperative on the part of the banks and FIs to put in place a transparent mechanism for the entire process so that the penal provisions are not misused and the scope of such discretionary powers are kept to the barest minimum. It should also be ensured that a solitary or isolated instance is not made the basis for imposing the penal action.

Guarantees furnished by group companies

While dealing with wilful default of a single borrowing company in a Group, the banks / FIs should consider the track record of the individual company, with reference to its repayment performance to its lenders. However, in cases where a letter of comfort and / or the guarantees furnished by the companies within the Group on behalf of the wilfully defaulting units are not honoured when invoked by the banks / FIs, such Group companies should also be reckoned as wilful defaulters.

Role of auditors
In case any falsification of accounts on the part of the borrowers is observed by the banks / FIs, and if it is observed that the auditors were negligent or deficient in conducting the audit, they should lodge a formal complaint against the auditors of the borrowers with the Institute of Chartered Accountants of India (ICAI) to enable the ICAI to examine and fix accountability of the auditors. With a view to monitoring the end-use of funds, if the lenders desire a specific certification from the borrowers auditors regarding diversion / siphoning of funds by the borrower, the lender should award a separate mandate to the auditors for the purpose. To facilitate such certification by the auditors the banks and FIs will also need to ensure that

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appropriate covenants in the loan agreements are incorporated to enable award of such a mandate by the lenders to the borrowers / auditors. Role of Internal Audit / Inspection. The aspect of diversion of funds by the borrowers should be adequately looked into while conducting internal audit/inspection of their offices/branches and periodical reviews on cases of wilful defaults should be submitted to the Audit Committee of the bank. Reporting to RBI / CIBIL Bank/FIs should submit the list of suit-filed accounts of wilful defaulters of Rs.25 lakh and above as at end-March, June, September and December every year only to Credit Information Bureau (India) Ltd. (CIBIL) from the quarter ended on March 31, 2003. Banks/FIs should, however, submit the quarterly list of wilful defaulters where suits have not been filed only to RBI.

Grievances Redressal Mechanism

Banks/FIs should take the following measures in identifying and reporting instances of wilful default: (i) With a view to imparting more objectivity in identifying cases of wilful default, decisions to classify the borrower as wilful defaulter should be entrusted to a Committee of higher functionaries headed by the Executive Director and consisting of two GMs/DGMs as decided by the Board of the concerned bank/FI. (ii) The decision taken on classification of wilful defaulters should be well documented and supported by requisite evidence. The decision should clearly spell out the reasons for which the borrower has been declared as wilful defaulter vis--vis RBI guidelines. (iii) The borrower should thereafter be suitably advised about the proposal to classify him as wilful defaulter along with the reasons therefor. The concerned borrower should be

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provided reasonable time (say 15 days) for making representation against such decision, if he so desires, to a Committee headed by the Chairman and Managing Director. (iv) A final declaration as wilful defaulter should be made according to the view of the Committee on the representation and the borrower should be suitably advised.

Criminal Action against Wilful Defaulters: J.P.C. Recommendations

Reserve Bank examined, the issues relating to checking wilful defaults in consultation with the Standing Technical Advisory Committee on Financial Regulation in the context of the following recommendations of the JPC and in particular, on the need for initiating criminal action against concerned borrowers, viz. a. It is essential that offences of breach of trust or cheating construed to have been committed in the case of loans should be clearly defined under the existing statutes governing the banks, providing for criminal action in all cases where the borrowers divert the funds with malafide intentions. b. It is essential that banks closely monitor the end-use of funds and obtain certificates from the borrowers certifying that the funds have been used for the purpose for which these were obtained. c. Wrong certification should attract criminal action against the borrower.

Some of these stringent norms if implemented properly can reduce willful default. The literature on micro finance shows that peer pressure can indeed impact repayment behavior of a borrower without having to go through legal measures. Given the success of the micro-finance institutions banks are also now trying to have such innovative schemes.
7.5 Peer Pressure as a Mechanism to Reduce NPA

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Banks are now having tie ups with the small scale industries associations and with the guarantee of the association bank is providing small borrowers loans without collateral. In case of non-repayment it is the industry association that is going to put the pressure on the borrower. To avail this facility the borrower has to be a member of the industry association. In the process both association as well as a bank gain. Such tie ups are going on between SBT and Kerala SSI association, Canara Bank and Karnataka SSI association and so on. If these models become successful they can ensure loans to relatively small borrower with small or no collateral.

Thus we observe that collateral plays an important role in determining the default tendency, especially the willful default tendency. However, as mentioned above banks do not usually designate any borrower as willful defaulter. Our survey of banks lending shows no defaulters , even though in our personal discussions officials raise their suspicions about some defaulters being willful. Given this problem it is not possible to empirically test this hypothesis. In this background we tried to formulate a theoretical model that captures the relation between collateral and willful default.

7.6 Bayesian Game of Willful Default and Collateral

From our survey it has been observe that personal loans and loans under various government schemes face much higher rate of default than the SSI loan provided with proper collateral. This provide a basis to infer that lack of collateral security do provide inducement for willful default. To formalize the strategic behaviour of the borrowers we therefore intend to formulate a theoretical model to examine the relation between the value of collateral security , time to retrieve the same and the occurrence of willful default.
The Model

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The model comprises 3 players viz., nature , borrower and the lender , the last player in this case is the commercial bank. The important point to note here is that a bank does not have information about whether a borrower is potentially a willful defaulter or not. Thus it is appropriate to assume that nature chooses at random from two types of borrowers, viz., willful defaulters (W) and non-defaulters (NWF). In a small scale sector a genuine defaulter is usually the one with lack of sufficient knowledge about production and marketing management and hence do not follow any strategic move for default. Therefore in our analysis we do not bring in this group of defaulters separately. Since default is empirically seen to have link with collateral value we consider two types of moves followed by the borrowers. A borrower firm may be ready to either provide a large or a small collateral. Depending on willingness to pay large (L) or small (S) collateral, a bank may decide either to disburse fund to the borrower or not to disburse. The game tree can be represented as follows:

Fig. 7.1

Firm Willful

Large Col

Bank

Disburse loan

Not disburse

Nature

Small col L

D ND

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Next to derive the pay-offs we make the following assumptions: Loan Period = Time to retrieve collateral in case of default= T Loan amount = X Per period return from investing in the project= Discount factor = We further assume that by diverting the loan amount a willful defaulter earns a higher return , per period.

Pay-off for the firm

A firm willfully deciding to default faces the following gains and losses. Through willful default a firm may earn expected higher return for life time. But it loses collateral C after T periods where C can be either large or small Total expected discounted pay-off (for say, large C) for the firm could be written as { / ( 1- ) }- Clarge T On the other hand if the firm decides not to default its expected discounted pay-off is

/ ( 1- )- X ( 1 + r lending)
Pay-off for the bank In case of default, the bank loses the principal as well as interest but receives the collateral after T periods. -X ( 1 + r lending) + Ci T ,
i = large, small

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However, in the no default case bank earns the principal with interest after period. X ( 1 + r lending) On the other hand if the bank decides to give no loan it can invest the money in say, another bank at the market deposit rate . Present value of X will then be X only if we assume to be the same as the deposit rate. Suppose now that the bank can fix a collateral large enough such that pay-off to the defaulter is negative: { / ( 1- ) }- Clarge T< 0

Equilibrium Strategies
As mentioned above a bank does not have information about whether a borrower is potentially a willful defaulter or not. Suppose the bank has prior belief that the probability of a borrower is a Willful defaulter = q. Suppose it follows the following strategy , disburse loan only if collateral is large. If we assume that a borrowers strategy is to give a large collateral if he is not a willful defaulter and small otherwise, will this strategy profile constitute a Bayesian Nash equilibrium ?

Posterior Probability
Given these beliefs the Posterior Probability as conceived by the bank that the borrower is a willful defaulter when large collateral can be computed as

Prob ( WF Large) = { Prob ( L WF). Prob (WF) }/ { Prob ( L WF). Prob (WF) + Prob ( L NWF). Prob (NWF)}

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= 0. q / 0. q + 1. (1-q)=0 Posterior Probability as conceived by the bank that the borrower is a willful defaulter when small collateral is given: Prob ( WF Small) = { Prob ( S WF). Prob (WF) }/ { Prob ( S WF). Prob (WF) + Prob ( S NWF). Prob (NWF)} = 1. q / 1. q + 1. (1-q) = q It can be easily computed that Prob ( NWF Large) = 1 Under condition (*) a willful defaulter will not come forward to take a loan. Thus given the posterior beliefs, the stated strategies can be sustained as equilibrium strategies. In the process bank can ensure a separating equilibrium whereby it separates the willful defaulters from the non willful ones. However, many genuine borrowers do not possess such high collateral and are forced to stay away from the formal lending system. Thus, the important question that arises is can the borrowers providing small collateral be sustained as an equilibrium? More precisely we consider the following strategy profile:

Firm: give small collateral

Bank : give loan whether collateral is small or large. Can this strategy profile constitute a Bayesian Nash equilibrium? Posterior Probability as conceived by the bank that the borrower is a willful defaulter when small collateral is given:

Prob ( WF Small) = { Prob ( S WF). Prob (WF) }/ { Prob ( S WF). Prob (WF) + Prob ( S NWF). Prob (NWF)} = 1. q / 1. q + 1. (1-q) = q

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It is optimal for bank to play this strategy iff q(-X ( 1 + r lending) + Csmall T)+ (1-q)X ( 1 + r lending) > X Let X = X ( 1 + r lending) Then we have condition for giving loan with small collateral, (1-2q) X > X - qCsmall T.(**) We next try to represent condition (**) in terms of a simple diagram. Here we measure q in the X-axis and pay-offs in the Y-axis. Line AB represents LHS of (**) and line XD represents the RHS. The intersection of the two lines and the resulting q value shows that if probability of willful default is low enough , that is, it lies within OF, then small collateral may be acceptable for banks; otherwise bank will demand large collateral. However, if through proper regulatory changes , time to retrieve collateral can be reduced then the line representing the RHS of (**) shifts down to XE. This in turn increases the tolerable limit for q for a bank to allow small collateral. Thus if the policy makers feel that due to the insistence on large collateral many genuine borrowers are unable to borrow then reducing the time T for collateral retrieval through legal reform is essential. During our survey we have not seen a single record where a court case has been decreed and a bank could actually took possession of the collateral.

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Fig. 7.2
P a y -o ffs

A
X

T fa lls X

RHS X- CS T

D
q

1 q FG

LHS

B
-X

S m a lle r co lla te ra l ca n b e a c ce p ted

363

Thus naturally an optimal strategy for the bank to insist on large collateral. The policy often followed in such circumstances is to compel the banks to lend without or minimal collateral. Well intended loans under various government schemes fall under this category. Banks then have to lower the collateral level and without improvement in legal mechanism to retrieve collateral these lending becomes NPA for the bank. This has indeed been observed during our survey. In order to understand the problem of default empirically we have used the data collected from the selected bank branches (see Section 7.2) in a probit model.

7.6 A Micro Level Analysis of Default

Analysis of the determinants of NPA carried out in Chapter 4 is based on aggregative data from each bank. Having collected micro level data on the SSI and other loan accounts including personal loans, from selected banks we next tried to look at the determinants issue more closely for such small loans in urban areas52. From the banks we have collected information on both NPA and non-NPA accounts and several other indicators. However, as mentioned above much of this information is not uniform across banks and some figures are not reliable. In this background as a first step we estimated a probit model to look at the factors that determine whether an account would be NPA or not. Thus NPA is a binary variable and it is our dependent variables. Independent variables are loan amount, rate of interest and year of establishment of the company. These are the three variables for which we have consistent information from different banks. The model under consideration is as follows: NPAi = 0 +1 (real_col) i +2 (rate of interest) i + 3 (year of establishment) i + 4 (loan under any scheme) i +5 (loan for SME) i + i i stands for the ith account/ unit. NPA = 0, if the account is an NPA account = 1, otherwise.

52

Given the confidentiality of this data we have not presented descriptive statistics etc.

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Similarly, SME and Scheme are dummy variables, showing whether the loan is under SME account and given under any Government scheme. The results of the probit estimates are presented in Table 7.2

Table 7.2 Probit estimates Log likelihood = -79.172511 Npa_Non Npa Real_collateral R_o_I (rate of interest) Scheme Year Sme_non SME Constant F(5) Prob>F Coefficient 5.02 -.2353688 .248585 .007379 -.058827 -12.04599 19.37 0.0016

Number of obs = 130 LR chi2(5) = 19.37 Prob > chi2 = 0.0016 Pseudo R2 = 0.1090 Std. Err. 1.89 .0769064 .4582996 .0165627 .3077299 33.37519 Z 2.66 -3.06 0.54 0.45 -0.19 -0.36 P>[Z] 0.008 0.002 0.588 0.656 0.848 0.718 130 0.1090

Number of Observation R Square

Probit Estimates Log Liklihood = -79.172511 The probit analysis most importantly shows the role of collateral in case of default. As the value of collateral increases , the loan has a greater probability of becoming non-npa. The above results also indicate that in case of the SSI sector interest rate has a positive relation with NPA. Probability of an account being NPA increases by .07 if interest rate increases by 1 unit. Thus we get an indication that Stiglitz and Weiss (1981) hypothesis is holding here. The other variables are turned out to be insignificant. But loan amount and NPA has negative correlation. An increase in loan size reduces the probability of an account being NPA in the SSI segment. Other variables are not found to be significant. It is important to note here that we have experimented with a number of variables such as loan amount , interaction effects etc. Loan amount and collateral values are found to be

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correlated and therefore only one of them viz., collateral has been chosen. All othe variables and interaction effects are not found to be significant. Out of these default accounts there is no account designated as willful default. However, the bank officials are sanguine about certain accounts being genuine default due to business failure or other contingencies while they are doubtful about a few other accounts. Accordingly, we have categorized the NPA accounts as genuine and not so genuine and tried to identify the determinants through a probit model (Table 7.3). It must be noted however, that none of these doubtful accounts are legally proved to be willful. Within the category of genuine default, given the reason of default, we have categorize them into two groups: genuine and not so genuine53. Genuine_noti = 0 +1 (real_col) i +2 (rate of interest) i + 3 (loan under any scheme) i +4 (loan for SME) i + i The variable Genuine_noti = 0, if genuine default = 1, if not appear to be very genuine

Table 7.3 Genuine_not Real collateral value Rate of Interest SME or Non -SME Scheme Constant F(4) Prob>F Log Likelihood Coefficient -5.21 .1547729 -2.031614 .4600827 -.4055754 40.33 0.000 -33.255995 Standard Error 3.59 .0777499 .5602071 .8556752 1.108938 Z -1.45 1.99 -3.63 0.54 -0.37 P>[Z] 0.147 0.047 0.000 0.591 0.715 78 0.3775

Number of Observation Pseudo R Square

53

This classification is entirely of the researcher.

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Two interesting results are derived from this part of the analysis. As rate of interest increases chances of a loan being defaulted under willful category rises. Thus possibly people do take more risky ventures intentionally with high rate of interest. Secondly, loan from the SME accounts tend to be more of genuine default type while loan from the personal account (with low or no collateral) tend to be of willful default category.

People tend to default somewhat intentionally when loan is given under a Government scheme. However, possibly because such accounts are very few, this variable is not significant.

7.7 Conclusion

In this chapter we tried to look at the problem of NPA concerning the SSI sector as well as of the other small-size accounts such as personal loans, from the point of view of a bank. Our discussions with the bank officials reveal that NPA concerning the SSI sector is reducing rapidly while from the personal loan segment it is increasing. Banks are now having tie ups with the industry associations through which they intends to create a peer pressure on the borrowers and also try to reduce willful default. An analysis of the NPA accounts shows that interest rate has a positive impact on the probability of an account being NPA. In addition, the value of collateral plays a significant role in determining whether an account will be NPA or not and more importantly whether default will be intentional. The latter can be seen from the fact that personal loans (usually without collateral) have higher probability of being willful default account.

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CHAPTER 8 Concluding Remarks

The financial system of any country consists of specialised and non-specialised financial institutions, organized and unorganized financial markets, financial instruments and services, which facilitate transfer of funds. Commercial banks form a major part of financial system in any country in general and in the developing nations in particular. This is mainly due to the fact that the other financial markets are not usually well developed. In India, financial system has been synonymous with banking sector. The importance of banking system in India can be noted by the fact that the aggregate deposits stood at 55 percent of GDP and bank credit to government and commercial sector stood at 26 percent and 33 percent of GDP respectively in 2004-05. Over time however, the Indian financial system has undergone significant changes in terms of size, diversity, sophistication and innovation. The financial sector reforms in India began as early as 1985 itself with the implementation of Chakravarti committee report. But the real momentum was given to it in 1992 with the implementation of recommendations of the Committee on Financial System (CFS) (Narasimham, 1991). In the post reform period India has a comparatively well-developed financial system than before, with a variety of financial institutions, markets and instruments. Due to the social banking motto of the Government, the efficiency of operation and profit earning capabilities are not considered as important criteria for evaluation of the performance of a bank. Consequently, the problem of non-performing asset (NPA) was not an issue of serious concern in India in the post nationalization (of banks) period. However, with the recent financial sector liberalization drive, this issue has been taken up seriously by introducing various prudential norms relating to income recognition, asset classification, provisioning for bad assets and assigning risks to various kinds of assets of a bank. While the Reserve Bank of India (RBI) as well as the commercial banks have begun to pay considerable attention to the NPA problem, there are only a limited number

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of rigorous studies in the Indian context that look at this issue in some detail. The current research project has been taken up in this background. Given that the NPA has strong implications on the health of the commercial banks and also the economy, it is essential to take measures to reduce the NPA levels in the commercial banks. This calls for identification of the factors that can cause an asset to become NPA. In order to understand this, the study has looked at the data of about 94 banks from 1997-2005 in a panel data framework. We examine whether proportion of rural branches, size of a bank, state of the economy (measured by GDP) , rate of interest and other related variables have impact on NPA levels. It has been found that rural branches indeed contribute to creation of NPA in general. However, in the case of NPA arising from the SSI sector rural branches do not have a negative impact. Rate of interest on the other hand does not seem to have a significant impact on the non-repayment of loans. Some of these results need to be examined carefully once again, in order to arrive at appropriate interpretations. We have also looked at the efficiency of the commercial banks in generation of profit. We observe from our analysis that profit efficiency of the public sector banks have improved over the period (1997-2005) while efficiency of the private and foreign banks are more or less stagnant. Results show that while rural branches do not contribute to inefficiency, NPA levels do contribute to profit efficiency (which is something to be expected). We have also presented some results from our survey of the small firms and the banks that deal with such firms. Inadequate loan amount is considered to be a major reason for default by the firms. Both banks and small firms are aware of the presence of willful defaulters. Banks consider diversion of funds to more lucrative activities as the prime cause of willful default. Our discussions with the bank officials reveal that as the legal process takes a long time (at least 10 years) for confiscating the collateral, it is to the advantage of the borrower to invest money in other lucrative business such as real estate and earn higher profit. Our micro level analysis of data collected from the bank on NPA accounts from the SSI units however shows that interest has positive contribution towards creation of NPA accounts; more precisely, an increase in the rate of interest raises the probability of a default.

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For a comparison purpose we have also looked at the problem of NPA arising out of personal & other categories of loans such as vehicle or home loan. The problem of NPA given under personal loan seems a more serious problem than that of the SME sector. Intentional default is also comparatively more common in the segment mainly due to the fact that there is no security involved. However, the pressure tactics adopted by the public sector banks appear to have resulted positive impacts.

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