The Big Bank Theory: India’s Approach to NPAs

On the 2nd of January, the cabinet approved the merger of Bengaluru based Vijaya Bank, the Mumbai based Dena Bank with Bank of Baroda(BoB) in a deal which critics say is a huge loss for BoB and a tremendous coup for the tattered Dena Bank. Following the merger of these three state-owned banks, BoB stands to become the third largest bank in India –in terms of assets- after State Bank of India and HDFC.

This decision comes as a result of the Government’s recent drive to consolidate the balance sheets of Public Sector Banks which have recently been marred by Non-Performing Assets(NPAs).

What are NPAs and how are they caused?

In its most basic essence, a Non-Performing Asset is a loan that hasn’t been paid off and has remained overdue for a period of 90 days.

Here, there is a legitimate concern that the loan will not be paid off and there is no guarantee that the lender will receive the principal (or its interest) lent to the borrower. It is those assets in the books of financial institutions that do not have any returns.

There are several reasons that cause banks to incur NPAs on their sheets.

1. In some cases, such as that of a well-known airline baron there might be a willful default i.e. not replaying the loan amount in-spite of being able to. One of the best examples of willful default is that of Kingfisher Airlines Ltd.
2. Sometimes there might be a severe industrial crisis in the country. Industries strongly rely on banks to fund their expansion and if there is a crash in global markets, these businesses have no other choice but to default on their loans.
3. Other times borrowers inflate their net-worth and lie to banks about their assets. Due to a lack of due diligence in some poorly managed banks, these buyers are granted loans. When the loan is then defaulted on, the bank has no real collateral to collect from the defaulter.

Gross NPAs as a percentage of gross advances

Now, the question arises; shouldn’t the regulator take some steps to ensure that banks with a poor track record stop giving out questionable loans?

Well, this is where the RBI steps in.

What is the RBI’s Prompt and Corrective Action Framework?

When banks can’t meet certain regulatory requirements like minimum capital, return on asset and percentage of NPAs, the RBI puts the bank on its Prompt and Corrective Action list.

To ensure that banks don’t go bust, the RBI has put in place some trigger points to assess and take corrective actions on banks which are weak and troubled. The process or mechanism under which such actions are taken is known as Prompt Corrective Action, or PCA.

Banks are not allowed to re-new or access costly deposits or take steps to increase their fee-based income. They will also have to launch a special drive to reduce the stock of NPAs and contain generation of fresh NPAs. They will also not be allowed to enter into new lines of business. RBI will also impose restrictions on the bank on borrowings from interbank market.

When the bank is under severe scrutiny even salary hikes of top officials, recruitments and expansion of bank branches overseas or local is stopped. Currently, there are eleven Public Sector Banks and one Private Institution under PCA.

What is the end objective of having a bank merger?

Think of a bank as the six-subjects a first year MIT student has. Everyone starts off the 1st sem with 6 subjects; let’s say unfortunately, during the course of the semester you end up failing in –for example BE.

At this point you have two options. Option one — you can come back in December (in the middle of your holidays) and write the paper or you can do something else, you can do the whole course over again in your third semester.

Now on paper, no one wants to come back to Manipal in December. You’ll be set up in an old hostel room in 9th block and the mess food will be terrible. But, on the other hand, in your third semester you will have another 6 subjects –are you sure you can handle one more?

There isn’t a guarantee you can, but at the same time anything is possible.

The combined entity of these three banks will emerge as India’s third largest lender

A bank merger is something like taking option two. What happens is that in the case of BoB, Dena Bank and Vijaya Bank, there are going to be three separate identities fused into one massive bank.

Now the idea is that, with a larger bank and a more steam-lined pedagogy, this new banking entity will be able to offset the losses of the smaller banks and in doing so also bring down the net NPA ratio. Bank of Baroda’s net NPA ratio is 5.4%, Vijaya Bank’s is 4.1% and Dena Bank’s is a staggering 11.04%.

The combined entity is expected to have a net NPA ratio of 5.7%.

Another thing to note about this merger is that the new bank will be the third largest lender in the nation. With greater size, more efficient operation will follow and there will be tremendous utilization of existing branches in states where these banks have more presence.

A lot of overheads can be eliminated. For example, in states like Gujarat and Maharashtra both Dena and BoB have huge presence; and in Karnataka Vijaya Bank is dominant.

Regional synergy will improve and in a lot of ways these banks will look to compliment each others’ brand names.

Public Response

There have been 4 nation-wide bank strikes across the country in the past month due to rumors surrounding the merger. The bank strike held on the 8th and 9th was the second large-scale bank strike in the last 20 days, as bank employee unions strongly protest against bank mergers.

According to a PTI report, 10 central trade had also called for a nationwide general strike on January 8 & 9. The aforementioned trade unions have collectively placed about a dozen of demands before Centre and have been protesting against the anti-people policies of central government.

“Regular, permanent, perennial jobs are being replaced by casual, temporary, contractual and fixed-term jobs. From job-oriented growth, it became jobless growth and now it is growth with job losses,” the unions said.

All said and done, the Indian Banking sector is in tatters and the Narendra Modi Government’s 2014 manifesto is still miles away from being realised.

‘The truth is often a bully we are forced to be friends with’, and in this case the truth is that we still have a long journey of reform to go before we can have a vibrant-government free banking sector.