The Reserve Bank of India (RBI) has been one of the most aggressive central banks with its rampant spree of monetary tightening. The bank recently raised its key policy rate for the eleventh time since March 2010. The repo rate was raised by 0.5% to 8% currently. Not only has growth in the country seen some slackening but bad loans in the banking sector have also piled up. When the interest rate cycle increases, revenues of companies decrease as customer demand slows. At the same time, their interest burden goes up, leading to incidents of loan defaults. Almost all banks have now increased their base lending rates close to 11% currently. This rate was at around 8-8.5% at the start of the year, putting pressure especially on floating rate borrowers. Floating rate liabilities are reset almost immediately after a policy rate hike.
The growth in non-performing assets (NPAs) as a percentage of the bank's total portfolio was almost at a 5 year high in the first quarter of the financial year 2011-12 (1QY12). In the three month period from April-June 2011, the banking industry's gross NPAs rose by 7.6% to Rs 653 bn. For the overall sector, the gross NPAs are estimated at 3.5% of advances. This has been the highest growth of bad loans in a quarter since 2006. The RBI, who is the sole crusader against inflation, has warned of further policy tightening if inflation doesn't moderate. Any further increases in interest rates will wipe out corporate profits, and pinch customer's wallets even further.
Public sector banks are seeing a large share of this deterioration in asset quality. These banks are however blaming the shift to a system based recognition of NPAs for the sudden increase in bad loans. Earlier, the calculation for these banks was done at a branch level, and subject to the discretion of managers. With the loss of this human element of forgiveness, NPAs have shot up. On the positive side, this helps us get a more accurate picture of the bank's asset quality. However, there be may be a few more skeletons in the closet. Going forward, as smaller accounts below Rs 1 m migrate to the system more accounts may get classified as non recoverable. High interest rates and shift in NPA accounting system has proved to be a deadly cocktail for PSU banks. Their quarterly profits have grown by single digits on account of higher provisioning.
We believe that if and when the RBI decides to ease its rate hikes, bank's loan books will be under less pressure. The economy is however still seeing some signs of weakness. Infrastructure companies and small and medium enterprises (SMEs) will face issues in repaying their debt in a slowing economy. Real estate, airline, and microfinance firms are also cash strapped in the midst of a liquidity crisis. If these sectors do eventually default, it will have a cascading effect on the banking sector and the broader economy. While the RBI could step in by allowing banks to restructure some loans, it will be best if the 'TBTF' (Too Big To Fail) policy is shunned here as well.