Page 153 - DMGT512_FINANCIAL_INSTITUTIONS_AND_SERVICES

Financial Institutions and Services

Notes
4. interest and/or installment of principal remains overdue for two harvest seasons
but for a period not exceeding two half years in the case of an advance granted for
agricultural purpose, and
5. any amount to be received remains overdue for a period of more than 90 days in
respect of other.
Reasons
Banks are in the risk business. In the process of providing financial services, they assume
various kinds of risks viz. credit risk, market risk, operational risk, interest risk, forex risk
and country risk. Among these different types of risks, credit constitutes the most dominant
asset in the balance sheet, accounting for about 60% of total assets. The credit risk is
generally made up of transaction risk (default risk) and portfolio risk. The risk management
is a complex function and requires specialized skills and expertise. Any loophole on the
part of the management can lead into a big NPA for a bank.

Problems due to NPA
The Indian banking sector is facing a serious problem of NPA. The extent of NPA is
comparatively higher in public sectors banks. Some of the problems due to NPA:

1. Owners do not receive a market return on their capital. In the worst case, if the bank
fails, owners lose their assets. In modern times, this may affect a broad pool of
shareholders.
2. Depositors do not receive a market return on savings. In the worst case if the bank
fails, depositors lose their assets or uninsured balance. Banks also redistribute losses
to other borrowers by charging higher interest rates. Lower deposit rates and higher
lending rates repress savings and financial markets, which hampers economic
growth.
3. Non-performing loans epitomize bad investment. They misallocate credit from
good projects, which do not receive funding, to failed projects. Bad investment ends
up in misallocation of capital and, by extension, labour and natural resources. The
economy performs below its production potential.
4. Non-performing loans may spill over the banking system and contract the money
stock, which may lead to economic contraction. This spillover effect can channelize
through illiquidity or bank insolvency; (a) when many borrowers fail to pay interest,
banks may experience liquidity shortages. These shortages can jam payments across
the country, (b) illiquidity constraints bank in paying depositors e.g. cashing their
paychecks. Banking panic follows. A run on banks by depositors as part of the
national money stock become inoperative. The money stock contracts and economic
contraction follows (c) undercapitalized banks exceeds the banks capital base.

5. Lending by banks has been highly politicized. It is common knowledge that loans
are given to various industrial houses not on commercial considerations and viability
of project but on political considerations; some politician would ask the bank to
extend the loan to a particular corporate and the bank would oblige. In normal
circumstances banks, before extending any loan, would make a thorough study of
the actual need of the party concerned, the prospects of the business in which it is
engaged, its track record, the quality of management and so on. Since this is not
looked into, many of the loans become NPAs.

Contd....

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