Indian banking system is regulated by stringent norms. The overall credit environment is not akin to the predatory lending practices as witnessed in the west. Strict lending guidelines, higher provisioning norms and stringent reserve requirements ensure that the banks are well equipped to absorb unanticipated credit risk losses. And the credit goes to Reserve Bank of India (RBI), which regulates the Indian banking industry.
However, off late some sort of skepticism has crept into the Indian banking industry. With the total loan size trebling since 2005, potential bad debt niggles have started erupting. Higher interest rate environment has further put a strain on borrowers thereby impacting their repayment capacity.
So, has junk credit crept into the system or is higher interest rate environment impacting the capacity of borrowers to repay? We think it's latter.
Strict lending norms have ensured that gross non-performing assets (NPAs) of the Indian banking system are well below 3%. Thus, the possibility of junk debt creeping into the system is virtually zero. Although the proportion of unsecured loans increased during the credit boom (2005-2008) the overall ratio of such loans is low.
So, how do banks manage to keep the bad debt problem under control despite increasing their loan books year after year?
While part of the credit goes to stringent lending requirements we have to say that policy guidelines by RBI also have a role to play here.
For instance, banks are allowed to restructure the loans given to risky sectors (real estate & construction) rather than classifying them as NPAs. Restructuring allows reclassification of an NPA into a sub-standard/standard asset. This effectively camouflages the true NPA scenario prevailing in the banking industry. Further, it may be noted that the banks are also allowed to avoid booking losses on loans given to a few state owned air-line companies (e.g Air India).
It would be too premature to say that these provisions could ultimately lead to a systematic bad debt problem across the banking industry. However, it does conceal the true picture of the bad debt risk prevailing in the banking system.
Nonetheless, it may be noted that India is not grossly indebted like western economies. Lending is mostly carried out by banks. Prevalence of shadow banking is negligible. Lending exposure to risky sectors like infrastructure and real estate is highly regulated and not permitted above a stipulated limit either.
Thus, India may not have a structural bad debt problem as witnessed by the western world but it is also true that the current picture is not an accurate reflection of the true problem faced by the country.