Is the sunk cost fallacy dragging down public sector banks?

Jun 26, 2015

- By Vivek Kaul

Vivek Kaul
Twice a year, the Reserve Bank of India releases the Financial Stability Report. The latest report was released yesterday (i.e. June 25, 2015). Among other things it talks about the bad state of the public sector banks in India. And the numbers put out by the central bank are really scary.

The bad loans of the banking system as a whole stood at 4.6% of the total advances(or loans) as on March 31, 2015. This has shot up from 4% as on March 31, 2014. Within this the numbers of public sector banks look very bad.

The stressed assets of the public sector banks stood at 13.5% up from 11.7% as on March 31, 2014. The stressed asset of the overall banking system stood at 11.1% up from 10.7% as on March 31, 2014. In case of private banks the number stood at 4.6% of the total advances.

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What does this mean? The total amount of stressed assets are essentially obtained by adding bad loans and restructured loans. This number is then expressed as a percentage of the total assets held by the banks.

Hence, the borrower has either stopped repaying the loan he had taken on or the loan has been restructured, where the borrower has been allowed easier terms to repay the loan by increasing the tenure of the loan or lowering the interest rate.

Stressed assets of 13.5% in case of public sector banks essentially mean that out of every Rs 100 that banks have given out as a loan, Rs 13.5 has either turned bad or is in dicey territory as it has been restructured. In the recent past many of the restructured loans have turned bad. What this clearly tells us is that public sector banks have been using the restructuring route to essentially ensure postponing the recognition of a bad loan.

Further, the RBI Financial Stability Report states that: "current deterioration in the asset quality...may continue for few more quarters." One reason for this lies in the fact that the sunk cost fallacy may be at work.

What is a sunk cost? As Richard Thaler writes in Misbehaving-The Making of Behavioural Economics: "When an amount of money has been spent and the money cannot be retrieved, the money is said to be sunk, meaning gone. Expressions such as "don't cry over spilt milk" and "let bygones be bygones" are another way of putting economists' advice to ignore sunk costs. But this is hard advice to follow."

And what is sunk cost fallacy? Daniel Kahneman defines it in Thinking Fast and Slow as follows: "The decision to invest additional resources in a losing account, when better investments are available, is known as the sunk-cost-fallacy, a costly mistake that is observed in decisions large and small. The escalation of commitment to failing endeavours is a mistake"

And this escalation of commitment seems to be playing out with Indian public sector banks some of which may be giving out more loans to rescue their older loans. As economist Ajay Shah writes in a column in The Indian Express: "Some banks may be spending good money after bad, giving more loans to distressed companies to make it look like things are fine." He further estimates that nearly a third of the corporate sector is facing balance sheet distress.

The Financial Stability Report also lists out sectors which are in trouble. "Five sub-sectors, namely, mining, iron & steel, textiles, infrastructure and aviation, which together constituted 24.8 per cent of the total advances of scheduled commercial banks, had a much larger share of 51.1 per cent in the total stressed advances. Among these five sectors, infrastructure and iron & steel had a significant contribution in total stressed advances accounting for nearly 40 per cent of the total. Among the bank groups, public sector banks, which had the maximum exposure to these five sub-sectors, had the highest stressed advances," the report points out.

Of this infrastructure sector had the maximum amount of stressed advances as can be seen from the accompanying table. As the report points out: "shocks to infrastructure sector, mainly the power and transport sub-sectors, would significantly impact the system."

Contribution of stressed sectors to the advances as well as stressed advances (December 2014)
Source: RBI supervisory returns.

The report also points out by the private sector banks have largely managed to avoid the mess that the public sector banks are in. As the report points out: "Sectoral data as of December 2014 indicates that among the broad sectors, industry continued to record the highest stressed advances ratio at 17.9 per cent followed by services at 7.5 per cent. The retail sector recorded the lowest stressed advances ratio at 2.0 per cent. Private banks had the highest share of retail loans in their total loans at 27.7 per cent as against 17.1 per cent for public sector banks."

The focus of private banks on lending to retail has worked well given that the stressed assets of retail lending are at 2%. The small guy is paying up, the big companies are not.

To conclude, it is worth revisiting the escalation of commitment point that Kahneman makes in his book. As he writes: "The escalation of commitment to failing endeavours is a mistake of the firm but not necessarily from the perspective of the executive who "owns" a floundering project. Cancelling the project will leave a permanent stain on the executive's record and his personal interests are perhaps best served by gambling further with the organisation's resources in the hope of recouping the original investment-or at least in an attempt to postpone the day of reckoning."

Now replace the word "firm" with "public sector banks" and the logic stays exactly the same.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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1 Responses to "Is the sunk cost fallacy dragging down public sector banks?"


Jun 27, 2015 soley responsible for this mess;Govt. means Politicians and IAS Bureaucrats and their interference In Management of PSU Banks starting with appointment of CMDS and Loan sanctions and what not;
Committe headed by Kamath recommended closure of Indian Bank as it was in such a Bad state;What Govt. did ?Just Dumprd the report as non sense and put in more money into Indian Bank; window dressed and showed it as a profitable Bank;Now all those Bad loans dumped under the carpet started smelling;

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