Probing the links
between twin balance sheet crisis and external commodity shocks could lead to a
better understanding of the problem.
The Indian banking system faced a significant challenge
after 2011 with an increasing quantum of non-performing assets (NPAs). By the
late 2000s, NPAs (as a percentage of gross advances) had decreased to less than
3.5 per cent. The downward trend, however, did not continue as NPAs began to
rise in 2011 and peaked at 11.18 per cent in the fiscal year that ended in
2018. As expected, this rise occurred with the deterioration of the balance
sheets of non-financial firms, and this twin balance sheet crisis contributed
significantly to the deceleration of growth in the late 2010s.
It has been argued as a problem that the
problem relates to public sector banks because they have a disproportionate
share of NPAs. Poor management and governance issues in such banks stemming
from government ownership have been cited as the major causes of the crisis.
But government ownership does not explain the improvement in performance that
public sector banks saw throughout the 2000s. It is improbable that governance
improved suddenly and dwindled subsequently. Moreover, most of these NPAs arose
due to defaults by private sector non-financial firms, making it even more
difficult to accept the blame that’s been put on governance issues. Since this
narrative is simple and easier to communicate, it has stymied systematic
scientific research in the area.
Most importantly, the difference in the
business models of public and private sector banks has not received due
attention. At the beginning of the 2010s, public sector banks had significantly
higher exposure (per cent of total loans) to commodity-sensitives The Indian
banking system faced a significant challenge after 2011 with an increasing
quantum of non-performing assets (NPAs). By the late 2000s, NPAs (as a
percentage of gross advances) had decreased to less than 3.5 per cent. The
downward trend, however, did not continue as NPAs began to rise in 2011 and
peaked at 11.18 per cent in the fiscal year that ended in 2018. As expected,
this rise occurred with the deterioration of the balance sheets of
non-financial firms, and this twin balance sheet crisis contributed
significantly to the deceleration of growth in the late 2010s.
It has been argued as a problem that the problem relates to public
sector banks because they have a disproportionate share of NPAs. Poor
management and governance issues in such banks stemming from government
ownership have been cited as the major causes of the crisis. But government
ownership does not explain the improvement in performance that public sector
banks saw throughout the 2000s. It is improbable that governance improved
suddenly and dwindled subsequently. Moreover, most of these NPAs arose due to
defaults by private sector non-financial firms, making it even more difficult
to accept the blame that’s been put on governance issues. Since this narrative
is simple and easier to communicate, it has stymied systematic scientific
research in the area.
Most importantly, the difference in the business models of public and
private sector banks has not received due attention. At the beginning of the
2010s, public sector banks had significantly higher exposure (per cent of total
loans) to commodity-sensitive sectors such as iron and steel and textiles
compared to private sector banks. A careful examination of the data gives
overwhelming evidence that a large fraction of the difference between NPAs in
the public and private sector banks arose due to differences in their business
models. Sectors such as iron and steel and textiles compared to private sector
banks. A careful examination of the data gives overwhelming evidence that a
large fraction of the difference between NPAs in the public and private sector
banks arose due to differences in their business models.
The rise in NPAs from 2011 onwards coincides with the fall in
international commodity prices. The earlier episodes of decline in prices in
the late 1990s and 2009 had strained the balance sheets of banks in India as
well and these two earlier episodes of decline in prices were not as prolonged
and severe as the one between 2011-16. It is because of the commodity price
boom in the last two years that despite the worst kind of economic crisis due
to Covid-19, we have hardly heard about any stress in the banking sector during
the pandemic.
This close link between commodity prices and
non-performing assets has stood the test of time and works via the worsening of
profitability of non-financial firms which, in turn, makes them default on
loans. A study of balance sheets of non-financial firms in India shows that the
profitability of firms and international commodity prices are tightly linked. A
decline in commodity prices leads to a decline in raw material costs but it
also leads to a more than proportionate decline in sales revenue. And that,
combined with fixed labour costs, crunches the margins of these firms and their
loan repayment capacity.
For example, suppose a firm borrows Rs 5 lakh
when the price of its main output was Rs 10 per unit. It will find it hard to
pay back the loan if the price decreases to Rs 5 per unit and it is not able to
sell a significantly higher quantity of output. A large number of borrowers in
commodity-sensitive sectors faced this situation during 2011-16 when the
non-energy commodity prices declined by about 35 per cent and metals prices
declined by 45 per cent. In other words, large adverse movements in prices,
compared to the projected prices in 2010 and before, on which business
decisions were made caused higher corporate default. Hence, we find that banks
exposed to commodities whose prices declined experienced a higher build-up in
NPAs compared to banks not exposed to these sectors.
However, as banks lend to several sectors
with heterogenous price movements, the estimation of the effect of movements in
prices on NPAs becomes slightly difficult. To overcome this, we create a
nominal price index using novel data on banks’ sectoral exposure (percentage of
loans to a sector) and commodity prices. For each bank, we multiply the exposure
with the sectoral price in that year and sum it over all the sectors to obtain
the nominal price index. This nominal price index is distinct for each bank
every year and captures the bank-wise heterogeneity in exposure to the
commodity prices. This nominal price index can change due to changes in
exposure to sectors or changes in prices associated with these sectors.
We estimate the impact of changes in
commodity prices on NPAs by allowing the nominal price index to vary due to
prices alone and find that banks which experienced a higher decline in prices
also experience higher amounts of defaults and hence higher NPAs. Also, these
models explain about 30 per cent of the increase in NPAs in the 2010s. As
mentioned before, public sector banks generally had higher exposure to
commodity-sensitive sectors, hence they experienced a relatively higher decline
in prices and a bigger rise in non-performing assets after the price crash of
the 2010s.
The ramifications of the aforementioned
findings are critical. First, it helps us decipher the twin balance sheet
crisis of the 2010s which affected growth adversely and has not been understood
so far. Second, a large proportion of NPAs arose because of exogenous shocks,
which have nothing to do with management and governance issues in public sector
banks. We believe that our work will drive more systematic research in this
area which will lead to a better understanding of the twin balance sheet crisis
of the 2010s and inform our way forward for appropriate banking reforms.
Source | INDIAN EXPRESS | 12th October 2022
Regards!
Librarian
Rizvi Institute of Management
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