NPAs - Write offs - Waive Offs - Can India bank on its banks?

One of my friends highlighted recent RTI information from RBI about NPAs and write-offs citing an article from Indian Express.

Before going into the details mentioned in the article, let me go through the technical terms like Stressed assets, NPA, provisions for bad debts, Write-off, Waive-off, and ARC (Asset Reconstruction Company).

Stressed assets - A loan is an asset for the bank since it earns interest on loans. A stressed asset in banking terminology is any loan that has become an NPA and undergoing a legal process for recovery. So, what is NPA?

NPA - NPA is an acronym for Non-Performing Asset. A loan is termed as NPA when the repayment of principal or interest is not made as per the schedule for more than 90 days. Every loan given by a bank will have a certain risk of default. Banks will assess such risk at the time of disbursement of loan and such risk is actually covered by provisioning for bad debts at the end of every financial year. So, what is this provisioning for bad debts?

Provision for bad debts - This is a technical procedure followed by the banks based on the risk perception of the loans disbursed, available data on loan defaults of existing & past loans, and consideration of external national and international factors. In this procedure, banks keep a certain amount of profits earned during that financial year to cover the losses arising out of NPAs.

Write-off - Technically, a write-off is a procedure where banks sell some of their NPAs to Asset Reconstruction Companies (ARCs) which purchase the book debts of banks at a discounted rate and recover the payments from the stressed assets. Here we have to observe a few things. Banks will not write off every NPA. Some NPAs will be pursued by the banks for recovery and some will be sold to ARCs at a discounted rate. So, what is the role of ARCs in NPA recovery and banking in India?

ARC - Asset Reconstruction Companies - These are the non-banking financial institutions that work in secondary markets. They buy stressed assets from banks at a discounted rate. They work with different models. Depending on the risk perception of the NPAs, they buy some NPAs with instant cash. i.e., they pay the accumulated interest & principal by deducting a certain percentage as commission and recovery charges. 

For ex, if a bank is selling Rs 100 (Principal+accumulated interest) NPA to an ARC, an ARC may purchase it by paying Rs 60-70 based on their risk perception. The remaining Rs 30-40 is covered by the bank from the provisions for bad debts. 

In some models, ARCs will not pay the NPAs immediately. They will recover the outstanding, transfer the amounts to the banks and then recover the charges for recollection from the banks. (Literally, they act as recovery agents for the banks). 

All the ARCs are managed through the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 which defines the class of stressed assets that can be transferred to ARCs, and the procedures to be followed by the banks & ARCs for recovery of loans with securitized loans and non-securitized loans. This policy is governed and monitored by RBI periodically.

Banks generally compute NPAs at the end of every quarter and report them to RBI and to shareholders through their balance sheets. Let's see why banks write off certain NPAs at a later stage.

Waive-Off - Waive-off is a procedure where the banks or NBFCs provide an exemption for their customers from repaying the loan outstanding either in part or in full.

If we observe the above definitions, the customer is relieved from repayment of loan principal or interest only in the case of loan waive-off. 

Technically, a write-off is an arrangement by the bank to treat certain stressed assets off the balance sheet. How & why is this important for banking to function smoothly is an important aspect to be understood before understanding its impact on banking and the public.

We all know how banking works. But if I have to make an analogy with any natural process, I would like to compare the banking of any country with the blood circulation system of humans. This circulatory system collects the blood from the organs to the heart through arteries and distributes it back to the organs through veins. 

This is very much similar to the primary objectives of banking. Banking collects funds from the public as deposits and distributes the same funds as loans. Similar to the circulatory system dependent on the respiratory system for the supply of oxygen, banking is dependent on the central bank and government for the regulation of funds. (This includes regulation of credit flow in the market through adjustment of interest rates or infusion of funds into the banking system and giving guidelines to banks for operating in a homogenous way).

(The above process of collecting deposits and disbursing loans is simplified to make it understandable for all readers).

If we observe the whole banking process, the deposits of customers become a liability for the banks apart from the capital induced through stock markets as they have to pay interest on those deposits. The loans disbursed by the banks become their assets as they earn interest and fees on those loans.

But all loans are not assets. When the loans are not recovered, the bank has to still pay the periodical interest on their customer deposits. The complexity of the banking system arises here. The banks are supposed to report their deposit and loans periodically to various interest groups like depositors, shareholders, and for compliance purposes.

A balance sheet is one important financial document that gives an overview of the assets and liabilities of a company. Since banking also deals with assets and liabilities, they should also prepare and report the balance sheet periodically. 

As mentioned above, deposits are liabilities for banks and loans are assets. So, the balance sheet of banks will have the amounts that they received as deposits & the amounts disbursed as loans and outstanding loans as of the reporting date. Also, I mentioned that all loans are not assets. So, the unrecovered loans or interests become the liability of the banks.

Over some time, banks accumulate deposits, loans, and unrecovered loans (NPAs). Loans can become NPAs due to various reasons like internal & external frauds, loss of life of the client or loss of income source by the clients, legal disputes leading to the closure of businesses, and any other external factors.

So, there are several options for banks to recover NPAs. 

1. Pursuing the NPAs until they are recovered by the banks themselves.
2. Pursuing the NPAs for a certain period and transferring the risk of collection to another company (ARC).
3. Waive off the loan amount and adjust it from the provisions for bad debts.

Why should banks go for the second and third options when they can follow up for recovery by themselves?

The NPAs will be accumulating periodically. This becomes a snowball after a certain period if they were not taken out of the balance sheet and eats up the operational profits of the banks in the present financial year for the loans which were disbursed years before. This will have a negative impact on the overall operations. To reduce the impact of NPAs on the balance sheet, banks go for writing off certain loans or waive-offs in rare scenarios.

I hope the readers were able to differentiate between a write-off and a waive-off by this time.

If some readers still have a doubt, let me explain it in simple terms.

A write-off is not equal to a waive-off. A write-off is moving a stressed asset from the balance of a bank into a non-balance sheet item. Banks still pursue such stressed assets through ARCs and through legal procedures whereas a waive-off is indemnifying the customer from the whole process of loan repayment.

Now, coming to the point discussed in the article by Indian Express and other news portals.

Yes, Indian banks have written off Rs 2,09 lakh crores of loans in FY23, Rs 10.57 lakh crores in the last 5 years, and Rs 15.31 lakh crores in the last 10 years. Further, the author claimed that the defaulted loans, including write-offs in the last three years, are 7.47% of the total advances of all banks.

So, what does this mean?

The above figures mean that Indian banks have moved Rs 2.09 lakh crores in the last financial year from their balance sheets and Rs 15.31 lakh crores in the last 10 years which amounts to 7.47% of the total loans extended by the Indian banks till March 2023 whereas the banks reported the NPAs as 3.9% of the total advances as they excluded the written-off loans from NPAs.

Should there be a need to panic?

As far as the technicalities of the banking are concerned, there is no need to panic as the banks complied with the existing laws and rules thereby reporting only the NPAs in the balance sheet as a percentage of total advances. 

If we look from a critical perspective, we can argue that if the banks are still pursuing the recollection of written-off loans they must be included in reporting the NPAs as a percentage of total advances. This argument is there since the early 20th century when banking was formalized in many countries, but there is no substantial argument for why such loans should be included as a percentage of a component(total advances) in the balance sheets when the loans are taken off from the balance sheets. And this debate continues.

Below is the RBI data on write-offs in the last 10 financial years.

If we look at this data, we can see an increasing trend in write-offs. But looking at this data in isolation is not the right way to analyse it. Below is the gross NPA percentage as reported by the banks to RBI. 

If we look at the data, it is clear that there is a downtrend in the gross NPAs reported from FY2020. Even if we deny this report and go by 7.47% as calculated in the article, we are still 4% less than the highest gross NPAs (FY2018).

Coming to the aspect of recovery discussed in the article.

It was mentioned in the article that Rs1.09 lakh crores were recovered from Rs 5.86 lakh crores written off in the last three years taking the recovery to only 18.60%.

I find this piece of information inconsistent with the remaining information sought by the RTI applicant. If we are looking at the NPA and written-off data for the last financial year, 5 years, and 10 years term, looking at the recovery for only three years makes it difficult to see any trend or pattern in the recovery to match with the written-off data.

It was mentioned that the banks were able to recover Rs 45,548 crore in FY23. If we look at that data, it is coming to ~21% of the written-off loans in FY23. We can take this as an optimistic recovery, but this deviates by almost 2.4% from the three-year average (18.60%) (This again creates confusion why we are looking at three-year data instead of 5-year or 10-year data in consistency with the written-off data. So, I am leaving it here and I suggest readers not to draw any conclusions from this data about recovery).

Coming back to the general POV. 

The percentages of written-offs are calculated on the overall advances extended by the banks and not on the advances extended in that particular FY. We can have high NPAs and write-offs in one FY even when there are fewer advances in that FY and vice versa.

Write-offs are not a new trend and there is no absolute data that points to a particular sector contributing to the maximum NPAs. NPAs are extended to both personal and corporate loans. Corporate loans being major tickets, obviously make higher figures though they are less in numbers. We cannot stop extending advances to the corporate sector by looking just at one data point (NPA). However, this NPA data must be used to strengthen risk management while extending loans by banks.

While commenting on the NPA data, my friend compared write-offs with the waiver of farm loans by various state governments and the public unrest about such waive-offs.

The farm loan waiver is a whole subject by itself. Whether we have to extend such support to the farmers or not is a big debate depending on the amount involved in such waivers, how the government is sourcing such funds, the cost of those funds, and the number of beneficiaries of such waivers. Governments should work on making farming self-sustainable instead of farmers waiting for farm loan waivers. Farming is dependent on a lot of external factors and as it supports the vital basic need of food, it definitely needs support from all sections of the society in one or the other form.

Note: I didn't go into the political POV of NPAs, write-offs, and farm loan waivers intentionally. Of course, there will be an impact of politics on every aspect of our life since lawmakers are political representatives. However, in my opinion, we have to keep them aside for a while, especially while sharing the technicalities of the subject and not the sociological aspects of the subject.