NPAs a hurdle for banks to pass on interest rate benefits: RBI paper

Asset quality issues in banks, with the rise in gross bad loans, have impaired transmission of monetary policy into bank interest rates, according to a research paper by the Reserve Bank of India (RBI) staff.

The paper stated that this has led to decline in the banks’ net interest margins (NIMs), which is one of the key indicators of the bank’s financial strength. NIM is the difference between interest earned on loans given and interest paid on deposits taken.

The paper titled ‘Asset Quality and Monetary Transmission in India’ was authored by RBI officials Joice John, Arghya Kusum Mitra, Janak Raj and Deba Prasad Rath.

These occasional research papers reflect their personal views and are not the RBI’s official views. However, they are a good indicator of the thinking within the central bank.

According to the paper, the asset quality of banks deteriorated steadily since 2011. The pace of worsening accelerated following the withdrawal of forbearance for restructured loans in April 2015 and the central bank’s asset quality review in the later part of 2015, starting July.

It added that the movements in NIMs of banks are one of the key indicators of effectiveness of monetary transmission.

The paper pointed out, “When the gross NPA ratio was high and rising, banks were not able to protect their NIMs as in a competitive environment, there are limits up to which banks can charge extra credit risk premia. NIMs of public sector banks, which had large NPA/stressed assets, were negatively impacted, while NIMs of private sector and foreign banks were not.”

At present, banks are sitting on a stressed assets pool of over Rs 10 lakh crore.

The paper said a bank with low default risk in its loan portfolio will be able to pass on interest rate changes of the central bank symmetrically on its deposits and loans.

In comparison, banks with high NPAs will seek to build up provision by increasing risk premium on performing loans, pushing up interest rates and hence the NIM.

“In the process, notwithstanding lower funding costs in response to the policy rate cut by the central bank and comfortable liquidity conditions, banks may not reduce their lending rates or may reduce them only partly, thereby impeding monetary transmission,” it added.

Gross NPAs of scheduled commercial banks increased from 3.4 per cent of advances in March 2013 to 4.7 per cent in March 2015 and further to 9.9 per cent by March 2017.

By contrast, bank NIMs, after increasing to 2.9 per cent in 2010-11 from 2.2 per cent in 2009-10, declined to 2.5 per cent in 2016-17, data showed.
The paper also highlighted that the banks did not make enough provisions or set aside capital towards potential losses.

“The provision coverage ratio (PCR) increased from 40.3 per cent at 2014 March-end to 41.9 per cent in March 2016 and further to 43.5 per cent at March-end 2017; this, however, fell short of the objective to have “clean and fully-provisioned bank balance sheets by March 2017” (Rajan, 2016),” said the paper.

With provisions and contingencies increasing by 45.2 per cent at the end of 2015-16 (Rs 2,09,400 crore), net profits shrank by 61.7 per cent.moneycontrol