Determinants of loan losses of Indian Banks: a panel study
| Pages | 17-32 |
| Date | 05 January 2015 |
| Published date | 05 January 2015 |
| DOI | https://doi.org/10.1108/JABS-04-2012-0017 |
| Author | Satyajit Dhar,Avijit Bakshi |
| Subject Matter | Strategy,International business |
Determinants of loan losses of Indian
Banks: a panel study
Satyajit Dhar and Avijit Bakshi
Satyajit Dhar is an
Associate Professor
based at the Department
of Business
Administration, University
of Kalyani, Kolkata, India.
Avijit Bakshi is an
Assistant Professor
based at the Department
of Business
Administration, Asia
Pacific Institute of
Management, Jasola,
India.
Abstract
Purpose –The purpose of this paper is to examine the factors that influence the variability of loan
losses (termed as non-performing advances or NPA in India) of Indian banks in the public sector during
the period of five years from 2001 to 2005.
Design/methodology/approach –The analysis is based on a panel approach, which considers both
spatial and time dimensions of observations. Panel regression was used to explore the impact of
different bank-specific factors on NPAs of 27 public sector banks (PSBs). Standard tests were used to
find out suitability of different models of panel data analysis. Eight bank-specific factors were identified
for analysis on the basis of review of extant literature.
Findings –Certain bank-specific factors, in particular, net interest margin and capital adequacy ratio
exhibit negative and significant impact on gross non-performing advances (GNPA) ratio of Indian PSBs.
The results also suggest that relative quantum of sensitive sector (SEN) (comprised of commercial real
estate, commodity and capital market) advances has a positive relationship with NPA ratio, and such a
relationship is statistically significant.
Research limitations/implications –The sample is restricted to India and may not be reflective of
other countries. The study considers bank-level factors, and there are some macro factors (e.g. gross
domestic product, interest rate and inflation rate) which could have explained the variability of GNPA
ratio.
Practical implications –Provisioning against loan losses is a major issue for stability of the banking
system. Identification of appropriate causes of variability of such loan losses is important for managing
credit portfolio of a bank. A positive and significant relationship between SEN advances and NPA calls
for a more cautionary approach toward lending to those sectors.
Originality/value –This paper is believed to be the first attempt to empirically examine the role of
bank-specific factors. This study attempts to enrich empirical research in the field and provides an
insight into the role of various bank-specific factors on loan losses in the context of Indian PSBs. The
study provides contrary evidence regarding the role of priority sector advances on a GNPA ratio.
Keywords Banking, Credit management, Indian banks, Loan losses, NPA, Panel analysis
Paper type Research paper
Introduction
The problem of non-performing assets (NPAs) has secured the attention of banking
institutions worldwide, as the accumulation of NPAs has caused a banking crisis and
rendered many banking institutions insolvent (Barr and Siems, 1994;Hou, 2007). To control
increases in NPAs, it is necessary to understand the factors that cause variations in these
non-performing loans. NPAs are also known as “loan losses”, “bad loans”, “problem loans”,
“delinquencies”, “stressed assets”, etc. The factors which are responsible for loan losses
are generally country-specific due to variations in regulatory frameworks and the roles of
central banks. The determinants of loan losses at banks in emerging economies have
received limited attention in the literature. Generally, emphasis has been given to
macroeconomic factors or to a composite set of variables consisting of both
macroeconomic and bank-specific factors. Limited work has been done in the Indian
Received 4 April 2012
Revised 14 December 2012
30 April 2014
Accepted 8 May 2014
DOI 10.1108/JABS-04-2012-0017 VOL. 9 NO. 1 2015, pp. 17-32, © Emerald Group Publishing Limited, ISSN 1558-7894 JOURNAL OF ASIA BUSINESS STUDIES PAGE 17
context to examine the determinants of NPAs for improving the functioning banking sector.
This is the main motive of our undertaking in this present research.
In this study, we undertook an empirical analysis to evaluate the impact of different
bank-level characteristics on the NPAs of public sector banks (PSBs). Our major objective
has been to explain the variability in NPAs, specifically to assess whether bank-specific
factors are good explanatory variables, given the homogenous ownership structure of the
sampled banks. The exercise is confined to PSBs to examine the determinants of stressed
assets within a class of institutions that is homogenous with respect to their ownership and
corporate governance arrangements and which comprises the greater proportion of the
banking sector assets of India. We used panel regression to determine whether a
significant relationship exists between the gross non-performing advances (GNPAs) of
PSBs and the selected bank-specific variables. We included all PSBs as our sample.
Further, our data which are from 2001, are more recent than those of other studies
[Rajaraman and Vasishtha (2002) sample period goes to 2000]. We have contributed to the
existing, but limited, body of research on the determinants of loan losses in the Indian
business context by providing empirical evidence that enables the assessment of the roles
of operational indicators on credit risk management at Indian PSBs.
The paper also contributes by providing evidence concerning the importance of
bank-specific factors as determinants of loan losses in the context of Indian PSBs. As a
brief preview of the main findings, the paper shows that net interest margin (NIM) is
negatively related to gross NPA ratios, i.e. the ratio of gross loan loss identified as per
regulatory requirements over total advances. Our analysis highlights the importance of two
other factors in explaining variations in NPAs. These factors are the capital adequacy ratio
(CAR) and sensitive sector (SEN) advances. The Basel II Accord emphasizes the role of
capital adequacy (bank capitalization as a percentage of risk assets) as the important
driving factor for the financial soundness of banks. In line with the findings of other studies,
our findings indicate that there is a negative relationship between capital adequacy and
GNPA ratios. Loans given by banks to some sectors (e.g. real estate and capital market)
are classified as SEN advances as per the stipulations of the central bank (known as the
Reserve Bank of India; RBI). A positive and statistically significant relationship was found
between SEN advances and GNPA ratios. Contrary to the findings of different studies, we
found no statistically significant relationship between priority sector advances (PRTs) (e.g.
advances to the agricultural sector and small sector industries) and GNPA ratios.
The rest of the paper is organized as follows. Section 2 reviews the related studies. Section
3 describes the methodology, sample and hypotheses. Results are reported in Section 4,
and Section 5 concludes the paper.
Literature review
We reviewed various empirical studies on NPAs that helped us understand how the NPAs
of banks react in relation to other bank-specific factors and illustrated their impact on the
performance of banks.
In an international context, NPAs are termed as “loan losses” and provisions against such
losses are made on the basis of the number of days, or at the discretion of the
management. Most of the studies in this context deal with the earnings management aspect
of loan loss provision. It is argued that managements have an incentive to resort to earning
management through provisioning, which is largely discretionary (Kim and Kross, 1998;
Ahmed et al., 1999;Labo, 2001). Chipalkatti and Rishi (2007) found that weak Indian banks
understated the magnitude of their NPAs during their study period of 1999-2001. The
signaling effect of loan losses provisions on share prices is another well-researched area
(Ahmed et al., 1999). There are a few studies that deal with the determinants of bank
performance or their lack of performance. Sufian (2010) examined the profitability of
Thailand’s banking sector during the post-Asian financial crisis period of 1999-2005. The
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