Cleaning the Books: How India Took on Bad Loans and Won

Introduction

The Indian banking sector has witnessed significant transformations in recent years, with regulatory measures aimed at improving financial stability and addressing the challenge of Non-Performing Assets (NPAs). The rapid expansion of credit in the early 2000s, coupled with weak risk assessment mechanisms, led to a surge in bad loans. This situation was exacerbated by external economic shocks and governance issues within financial institutions. Recognizing the urgency to restore stability, the Reserve Bank of India (RBI) introduced two key reforms—Prompt Corrective Action (PCA) and Asset Quality Reviews (AQRs). These regulatory interventions were designed to curb reckless lending, ensure early identification of stressed assets, and restore confidence in the banking system.

This article critically examines the impact of PCA and AQRs on NPAs and financial stability using key data points and theoretical insights. By analyzing the effectiveness of these measures, we can assess whether they have succeeded in fostering a more resilient banking sector in India. Furthermore, a comparative analysis with global regulatory frameworks will provide insights into best practices and areas for improvement.

Understanding NPAs and Financial Stability

Non-Performing Assets (NPAs) refer to loans or advances where interest or principal payments remain overdue for 90 days or more. They represent the financial health of banks and have far-reaching consequences for economic growth and stability. High levels of NPAs can erode banks’ capital base, reduce profitability, and constrain their ability to lend, leading to a credit crunch.

Financial stability, on the other hand, refers to a banking system’s ability to function efficiently, allocate resources effectively, and withstand economic shocks without triggering systemic crises. A stable banking sector is essential for economic development, as it ensures continuous credit flow to businesses and households. When NPAs rise unchecked, they create a domino effect, affecting bank solvency, investor confidence, and overall macroeconomic stability.

Regulatory interventions such as PCA and AQR aim to prevent banking crises by imposing corrective measures on struggling banks and enforcing stricter asset quality standards. These measures compel banks to strengthen risk management practices, improve transparency, and enhance governance. Understanding how these reforms have influenced NPAs and financial stability is key to evaluating their long-term effectiveness.

Prompt Corrective Action (PCA) Framework

What is PCA?

Prompt Corrective Action (PCA) is a regulatory mechanism introduced by the RBI in 2002 to strengthen weak banks and maintain financial stability. The framework sets specific thresholds based on three critical financial indicators:

• Capital Adequacy Ratio (CAR): Measures the bank’s financial strength in terms of its capital buffer.
• Net NPAs: Represents the proportion of bad loans after adjusting for provisions.
• Return on Assets (ROA): Assesses the bank’s profitability.

Therefore, it applies to banks that fail to meet financial thresholds which were related to capital adequacy, asset quality, and profitability. Specifically, a bank is placed under PCA if its Capital Adequacy Ratio (CAR) falls below 9%, Net Non-Performing Assets (NNPA) exceed 6%, or if it reports negative return on assets (ROA) for two consecutive years. Once a bank is under PCA, the RBI imposes restrictions such as limits on lending and dividend distribution, increased provisioning for bad loans, and a ban on opening new branches. The severity of restrictions increases as a bank’s financial health deteriorates, with the ultimate aim of preventing a crisis.

Impact on NPAs:

1. Reduction in NPAs: The gross NPAs of PCA-imposed banks declined from 14.6% in FY18 to around 9.5% in FY22, according to RBI data. This was due to stringent monitoring and forced recognition of bad loans, ensuring that banks actively addressed stressed assets rather than deferring them.
2. Improved Recovery Efforts: With the RBI closely supervising PCA banks, efforts to recover bad loans intensified. Measures such as one-time settlements and legal actions against defaulters were expedited, contributing to the decline in NPAs.

Explanation:

The PCA framework compels banks to shift their focus from aggressive credit expansion to loan recovery and risk mitigation. By restricting lending to riskier segments, it ensures that banks do not accumulate more bad loans. Additionally, under PCA, banks are required to increase provisioning for bad assets, making their balance sheets more resilient. The immediate impact is a spike in NPAs due to stricter classification norms, but over time, it leads to a healthier asset portfolio.

Impact on Financial Stability:

1. Enhanced Capital Adequacy: The average Capital Adequacy Ratio of PCA banks increased from 9.7% in FY18 to over 12% in FY21, ensuring that they had sufficient buffers to absorb potential losses.
2. Operational Discipline: The restrictions on expansion and lending forced banks to reassess their risk management strategies, leading to more cautious and stable banking operations.
3. Restored Market Confidence: As banks under PCA took corrective steps, investor and depositor confidence improved, reinforcing trust in the Indian banking system.

Explanation:

By enforcing corrective measures, PCA ensures that weak banks do not become a liability to the financial system. The capital infusion from the government and improved governance mechanisms have strengthened the banking sector’s stability. However, a short-term consequence of PCA is reduced lending capacity, especially for businesses dependent on bank credit. While this creates temporary credit constraints, the long-term benefit is a more robust and sustainable banking system.

Asset Quality Review (AQR)

What is AQR?

The Asset Quality Review (AQR) was introduced by the RBI in 2015 to ensure that banks accurately recognize and report Non-Performing Assets (NPAs) instead of concealing them. Previously, many banks engaged in evergreening, where bad loans were rolled over or restructured to avoid classification as NPAs. Under AQR, the RBI reviewed all loan accounts above ₹500 crore to check for stress and applied uniform loan classification norms across banks. If a loan was overdue for more than 90 days, it had to be classified as an NPA, even if restructured. Banks were required to disclose all stressed assets and make higher provisions (allocate more funds) for bad loans, which impacted their profits but enhanced transparency. Unlike the Prompt Corrective Action (PCA) framework, which continuously monitors weak banks and imposes restrictions, AQR was a one-time clean-up exercise aimed at revealing hidden bad loans and improving the overall health of the banking sector.

Impact on NPAs:

1. Surge in Recognized NPAs: After AQR implementation, reported NPAs increased sharply from 4.6% in FY14 to 11.2% in FY18, reflecting the extent of previously hidden bad loans.
2. Better Loan Classification: AQR enforced a standardized method of recognizing stressed assets, preventing banks from concealing bad loans through restructuring.

Explanation:

AQR forced banks to acknowledge the true extent of their bad loans. While this led to a sharp rise in NPAs initially, it was a necessary step toward cleansing the banking system. Before AQR, banks often delayed recognizing NPAs to present healthier balance sheets, which masked underlying vulnerabilities. By ensuring transparency, AQR laid the groundwork for effective resolution strategies.

Impact on Financial Stability:

1. Improved Balance Sheet Transparency: Banks became more accountable in reporting NPAs, fostering greater confidence among investors and depositors.
2. Higher Provisioning Requirements: Following AQR, banks had to allocate larger provisions for bad loans, reducing short-term profits but improving long-term financial health.
3. Temporary Lending Slowdown: The increase in NPAs led to a cautious approach in lending, particularly to corporate borrowers, as banks focused on cleaning up their books.

Explanation:

Although AQR created short-term stress, it was essential for ensuring a more robust financial system. By compelling banks to provision adequately for NPAs, it reduced the risk of financial instability caused by sudden loan defaults. Over time, this approach has resulted in stronger governance and a more transparent banking environment.

Visualizing The Impacts

The following chart illustrates the impact of the Prompt Corrective Action (PCA) framework and the Asset Quality Review (AQR) on Non-Performing Assets (NPAs) in India’s public and private banking sectors. It compares how public and private sector banks managed NPAs before and after regulatory interventions.

Data source: RBI database; Graph: Generated by the author.

Interpretation and Relevance to the Article

• Public sector banks had significantly higher NPAs than private banks, with a peak in 2016-2017. Private banks maintained relatively lower NPAs, indicating better credit risk management.
• The AQR, introduced in 2015, led to a sharp rise in recognized NPAs as banks were forced to fully disclose stressed assets. The impact was more severe on public sector banks, which had greater exposure to risky loans.
• The PCA framework, which imposed restrictions on financially weak banks, contributed to a decline in NPAs after 2018. Banks under PCA had to improve their financial health by reducing risky lending and strengthening capital buffers.
• The number of banks under PCA dropped from 12 in 2015 to just 1 by 2022, highlighting the recovery process and effectiveness of the regulatory measures.

Therefore, the chart supports the argument that regulatory actions like PCA and AQR were essential in stabilizing India’s banking sector. Despite short-term stress, these measures ultimately strengthened financial transparency and governance.

Theoretical Insights and Global Comparisons

The effectiveness of PCA and AQR aligns with the Regulatory Capital Hypothesis, which suggests that stringent regulatory oversight compels banks to maintain sufficient capital buffers. This hypothesis is grounded in the broader framework of prudential regulation, which ensures that financial institutions operate within risk-controlled environments.

International Comparisons:

• United States: The Dodd-Frank Act mandates stress tests and corrective actions for banks in distress, ensuring that financial institutions maintain adequate risk controls. This was introduced in response to the 2008 financial crisis, emphasizing capital buffers and early intervention.
• European Union: The Basel III norms require banks to maintain higher capital adequacy and enforce early intervention mechanisms like PCA. The European Central Bank (ECB) also conducts periodic stress tests to ensure that banks remain solvent under adverse conditions.
• United Kingdom: The Prudential Regulation Authority (PRA) enforces stringent capital and liquidity requirements on banks to mitigate systemic risks and prevent financial crises.
• China: The Banking and Insurance Regulatory Commission (CBIRC) imposes asset quality assessments similar to AQR to prevent excessive bad loans from destabilizing the banking system.

These global frameworks reinforce the importance of proactive banking supervision and demonstrate how PCA and AQR in India align with best practices in banking regulation worldwide.

Conclusion

The PCA framework and AQR exercise have played a vital role in addressing NPAs and enhancing financial stability in India. While these measures imposed short-term stress on banks and businesses, they have strengthened governance, risk management, and transparency in the long run. PCA has ensured that weak banks take corrective measures before their financial health deteriorates further, while AQR has enhanced transparency by forcing banks to recognize bad loans accurately.

Going forward, regulatory vigilance must remain strong to prevent a recurrence of past issues. The effectiveness of these reforms can be further enhanced by integrating technological solutions such as AI-driven risk assessment and predictive analytics for early detection of stressed assets. Moreover, continued coordination between the RBI, government, and financial institutions will be crucial in sustaining a resilient banking sector that can support long-term economic growth in India.