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Original Article

Dynamics of emerging India’s

banking sector assets: A simple
Received (in revised form): 17th February 2009

Soumitra K. Mallick
is Associate Professor at the Indian Institute of Social Welfare & Business Management, Management House, College Square
West, Kolkata, India. He holds a BCom (Hons) from St.Xavier’s College, University of Calcutta; and a CA from the Institute of
Chartered Accountants of India and a PhD from Department of Economics, New York University.

Amitava Sarkar
is Professor and Director of the School of Business Management, West Bengal University of Technology, Salt Lake, Kolkata, India.
He holds an MA in Economics from the University of Calcutta and a PhD from the Department of Economics, University of

Kalyan K. Roy
is Professor and Head, MBA department at the Indian Institute of Social Welfare & Business Management, Management House,
College Square West, Kolkata, India. He holds a BE degree from Bengal Engineering College, University of Calcutta and a PhD
degree from the Graduate School of Business, University of South Carolina.

Tamal Duttachaudhuri
is Chief General Manager, Industrial Investment Bank of India, Kolkata, India. He holds a MA degree from the Department of
Economics, University of Calcutta and a PhD degree from the Department of Economics, Johns Hopkins University.

Anjan Chakrabarti
is Professor, Department of Economics, Calcutta University, Kolkata, India. He holds a MA degree from the Department of
Economics, University of Calcutta and a PhD from the Department of Economics, University of Southern California.

Correspondence: Soumitra K. Mallick, Indian Institute of Social Welfare & Business Management, Management House, College
Square West, Kolkata 700 073, India
E-mail: smallick@iiswbm.edu

ABSTRACT Banking sector loans are the principal source of capital for small and
medium business ventures in India, comprising firms that are not large enough to be
registered with stock exchanges. Non-performing assets (NPAs) are an important measure
of the success of these businesses, as well as of their levels of discretion in carrying out
their commercial activities conditional on their role in developing India’s entrepreneurship
outside the stock markets. In this article we analyze certain properties of NPAs in Indian
Banks over the 1990s, when liberalization was introduced by opening up a significant
portion of the public sector, allowing private banks to do business. We arrive at three
conclusions for emerging India’s banking sector. First, NPAs (as a ratio of loans and
advances) are significantly sticky over time. Second, larger NPAs are associated with larger
advances and vice-versa. Third, NPAs do not seem to have spiraled out of control over the

& 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
Dynamics of emerging India’s banking sector assets

1990s. A simple cointegration test is carried out and a set of dynamic graphs, using notions
of ‘fibration’, is presented to support the results.
Journal of Asset Management (2010) 11, 62–70. doi:10.1057/jam.2010.1

Keywords: banking sector in emerging economies; dynamics; cointegration;

non-performing assets; ratio_p

INTRODUCTION Allen and Gale (2000), Kaminsky and

Banking sector loans are the principal source Reinhart (1999, 1996), Kiyotaki and Moore
of capital for small and medium business (1997), Stiglitz and Weiss (1981) and others
ventures in India, comprising firms that are have examined the factors that make the
not large enough to be registered with stock banking sector particularly fragile. The
exchanges. Non-performing assets (NPAs) or existing literature has expressed concern over
loans and advances that have defaulted on the inherent tendencies in the banking sector
their installment payments for two or more towards strength, arising out of institutional
quarters are an important measure of the characteristics with respect to norms/rules
success of these businesses, as well as of their and inadequate controls endemic to
discretion in carrying out their commercial emerging market economies characterized
activities conditional on their role in by incomplete asset markets (Geanakoplos
developing India’s entrepreneurship and Polemarchakis, 1986; Mallick, 1993,
outside the stock markets. This article 2006, 2007; Sarkar et al, 2001). A study of
analyzes the beneficial impact of a such strength is therefore important, as is
well-functioning banking sector on the the development of a measure to study
real sector through developing small and such strength. To bring out the dynamic
medium businesses outside the stock relationship, we discuss the historical values
markets in India. of NPAs as explanatory values for current
There are two aspects to the analysis. One NPAs in order to form a model for
is the importance of the banking sector in forecasting future NPAs, and hence the
the development of small- and medium-sized strength of the banking system in the case
businesses, and the other is the development of the emerging Indian market. This is a
of commercial banking itself through these simple approach, but as the analysis will
businesses. With the liberalization of the show it is a good model for the future
capital market, which includes the course of NPAs in the Indian banking
privatization of the public sector carried out system as a whole.
in the 1990s, the entry of private commercial Our empirical analysis brings out three
banks as well as the increase in commercial significant tendencies. First, NPAs (as a ratio
business as part of the overall portfolio of of loans and advances) are significantly
public sector banks made it necessary to take sticky over time. Second, larger NPAs
stock of how the Indian banking sector fared are associated with larger advances and
over the decade. This forms a measure of the vice-versa. Third, NPAs do not seem to be
success or failure of commercial banking in spiraling out of control; rather they are
emerging markets such as India. The showing signs of a slight reduction. The third
interdependence between the two sets of result throws positive light on a particular
factors has the potential to make the NPA aspect of commercial banking policy
values follow a complex dynamic series, followed by the Finance Ministry of India.
which needs to be modeled and analyzed. The policy initiated during the 1990s of

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Mallick et al

classifying bad debts as NPAs after two financial performance of banks has to be
installment defaults seems to have brought measured in terms of the efficient intake
the bad debt situation under control. and maturity of deposits and efficient
However, this study shows that the real and provision and recovery of loans and advances.
asymmetric information problems associated The two essential variables in this circulation
with bad debt formation requires serious mechanism are interest and bad debts.
attention, as the dynamically stable value is Interest received on loans and advances
significantly non-zero. forms the major part of the income of the
The article is organized as follows. In banking sector, while interest paid and bad
the next section we discuss the outline of the debts (technically renamed non-performing
model used for analysis. We then discuss assets) form the major part of the costs of
the data set, followed by the cointegration the banking sector. When comparing
test using a time series ARIMA (1,0,1) nationalized and private banks, as will be
Maximum Likelihood analysis linked with discussed in detail in the data section, it is
the graphical analysis with the data set and evident that NPAs are a formidable
the results. The last section concludes. problem for nationalized banks as opposed
to private banks. However, as nationalized
banks constitute a major portion of the
THE MODEL banking sector’s total deposits, as well as
Since the nationalization of the late 1960s loans and advances, because of its historical
and early 1980s, the banking sector in India priority on small savings and prioritized
has been largely state-owned, in the form lending, NPAs are a significant barrier to
of nationalized banks. As, until recently, the efficient functioning of the banking
shares of nationalized banks in India were not sector as a whole and a key factor in the
traded in the stock market, the financial financial strength of the banking system.
performance of banks is to be measured with Explanations for the level of NPAs are
respect to different criteria from those of not hard to find. To a large extent, as is the
companies listed on the stock exchange. In case with any industry, bad debts arise as a
addition, banking companies, being financial result of an inefficient system of management
institutions, belong to a different industrial and recovery of debt, along with the real
sector, and hence measures of performance economic causes of business failure. When
have to differ. Similar discussions on the applied to the banking sector, lending gets
economics of banking can be found in such coupled with bad debts as a possible
sources as Gurley and Shaw (1960) and explanation for the incidence of NPA costs.
Bagchi (1997). Thus, lending to bad-quality projects in
The purpose of this study is to assess the terms of both technology and risk;
extent of financial strength in the banking asymmetric information giving rise to
system over the period covering the 1980s imperfect screening and monitoring that
and the 1990s. This period witnessed results in adverse selection of projects and
significant structural change, involving the terms of lending; and moral hazard in the
opening up of the stock markets and the monitoring and recovery of loans (Stiglitz
trading of portions of shares of certain and Weiss, 1981) lead to the high incidence
nationalized banks, notably the State Bank of NPA costs. According to the definition
of India, in the stock market. However, of NPAs given by the Reserve Bank of India,
as the significant nature of operations of the these are loans and advances on which
banks remains the inflow and outflow of interest payment is in default for more than
credit through the mechanism of interest two quarters. Hence, they include not only
rates (that is, commercial banking), the bad debts, but also other loans and advances

64 & 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
Dynamics of emerging India’s banking sector assets

that fall into the risky category with respect 1800

to debt servicing. Thus, the broad definition 1400

of risk assets in the adverse selection and
moral hazard literature more or less coincides 1000

with the definition of NPAs. 600
An interpretation of the asymmetric
information literature as discussed above can 200
proceed as follows. Banks that have lent in
the past to high-default risk firms for priority 0.5 1.5 2.5 3.5 4.5 5.5 6.5
reasons or reasons related to adverse selection TIME

and moral hazards find it difficult to recover Figure 1: Bad debts over time (annual).
interest income and principal. This reduces
the debt-service-coverage-ratio of bank
deposits, thereby inducing them to lend to 180

higher-return, higher-risk customers. 140

Owing to the dynamic operation of the
adverse selection and moral hazard problems 100

this accumulates further NPAs. By this RATIO_P

argument, the aggregate implication is that
NPAs give rise to further NPAs in the Indian 20
banking sector. In this article, we pursue this
line of reasoning to test the time series 0.5 1.5 2.5 3.5 4.5 5.5 6.5
properties of NPAs. Hence, as will be seen, TIME

NPAs expressed as a function of outstanding Figure 2: Ratio-p over time (annual).

loans and advances are self-driven over time,
and this stickiness has given rise to a vicious
cycle of bad debts in the banking sector, in the previous section, bad debts and NPAs
which makes the entire financial system will be used interchangeably. The graphs of
fragile by impeding the operation of the the variables are given in Figure 1, which
multiplier. describes the plot of the bad debts (NPAs)
over time ranging from first half of 1995 to
second half of 2000. Figure 2 describes the
THE DATA SET plot of the NPAs to loans and advances ratio
The data set comprises the period 1995– (ratio_p) over time. Figure 3 describes the
2000, for which full data are available in the plot of Bad Debts against advances. This
Prowess database of the Centre for shows a significant clustering at small
Monitoring Indian Economy, and consists of advances and low bad debt levels. In
a maximum of 188 banking companies in addition, there seems to be a linear trend,
1998 and a minimum of 121 banking which we estimate in the next section.
companies in 1995. The variables that are Figure 4 describes the plot of ratio_p against
considered for the purpose of this study are as advances. This again shows a significant
follows: provision for bad debts (NPA) for clustering close to the origin. Furthermore,
the year, closing balance of loans and there seems to be a constant relation across
advances, and the year of operation. With levels of advances. Figures 5 and 6 are
these variables, we construct a composite three-dimensional graphs, plotting the Bad
variable 100  bad debts/loans and Debts and the ratio_p against advances and
advances ¼ ratio_p to express bad debts as a across time. This dynamic ‘fibration’
function of loans and advances. As discussed technique used in the graphical analysis of

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Mallick et al

time series helps in analyzing the time (see, for example, Granger and Newbold,
dimensional that represents structural 1977; Rao, 2000). While a clear picture does
parameters, essential in cointegration tests not seem to emerge graphically, a clustering
of points at the low advance–low bad debt
and low bad debt–advance ratio levels are
1800 clearly discernible over all the frames. How
these relations change (or remain sticky)
over time is analyzed in the Maximum
1000 Likelihood estimation in the next section.



The ARIMA (1,0,1) results of the single
-10000 10000 30000 50000 70000 90000 1.1e5 series (ratio_p) time series are presented in
ADVANCES Table 1. The ratio_p variable is regressed on
Figure 3: Bad debts vs. Advances (scaled). itself 1 period lagged and 1 period led. The
model is of the following nature:

110 ratio pt ¼A þ B1 ratio pt1 þ B2 ratio ptþ1

90 þ ~et ; ~et  Nð0; s2e; t Þ

The motivation for using a mixed lag-lead

model (ARMA model) to estimate the
30 outcomes of investment behavior in
10 contingent commodity models has been
analyzed theoretically to some extent in
-10000 10000 30000 50000 70000 90000 1.1e5 Mallick (1993, 2006, 2007). Mispricing of
ADVANCES assets in the sense of market failure has been
Figure 4: Ratio-p vs. Advances (scaled). shown to be a distinct possibility in such

Figure 5: Bad debts vs. Advances (scaled).

66 & 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
Dynamics of emerging India’s banking sector assets

Figure 6: Ratio-p vs. Advances over time (scaled).

Table 1: Model: (1,0,1) MS residual=40.730

Parameter Asympt. Asympt. p Lower Upper
SE t ( 914) 95% Conf 95% Conf

Constant 2.564742 0.259974 9.86537 0.000000 2.054526 3.074958

pt1 0.941871 0.063173 14.90940 0.000000 0.817890 1.065852
pt þ 1 0.928103 0.069250 13.40221 0.000000 0.792195 1.064010

Table 2: Parameter covariances model: (1,0,1) MS Table 3: Parameter correlations model: (1,0,1) MS
residual=40.730 residual=40.730
Constant pt1 pt þ 1 Constant pt1 pt þ 1

Constant 0.067587 0.004796 0.000373 Constant 1.000000 0.291996 0.020696

pt1 0.004796 0.003991 0.004306 pt1 0.291996 1.000000 0.984292
pt þ 1 0.000373 0.004306 0.004796 pt þ 1 0.020696 0.984292 1.000000

cases. However, initial assumptions on of 0.94 and the pt þ 1 coefficient

history are shown to be necessary conditions (autoregressive) is 0.93. Both these estimates,
in analyzing such equilibrium. This is why along with the negative constant, ensure
the constant intercept is necessary. Unlike the prediction of stability in the long run.
Mallick, we consider the Integral Process to Thus, the ratio of NPAs to Total Loans and
be trivial. Advances can be taken to be constant in
The parameters of the model are the short run. The inference that directly
estimated using the maximum likelihood follows is that greater values of advances are
estimation procedure (Tables 2 and 3). likely to be associated with greater default,
As is evident from the graphical analysis, while smaller advances are less likely to
the time series shows a significant secular be in default.
trend and a significant intercept. The pt1 There is a significant constant intercept of
coefficient (autoregressive) takes on a value –2.6, thereby signifying a reduction in the

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Mallick et al

Input: RATIO_P
120 120

100 100

80 80

60 60

40 40

20 20

0 0

-20 -20
-100 0 100 200 300 400 500 600 700 800 900 1000 1100 1200 1300 1400 1500

Observed Forecast ± 90.0000%

Figure 7: Ratio-p vs. no. of observation (scaled).

bad debt problem that does not change over instalments’ default seems to have brought
time with the volume of advances by the some amount of control to the bad debt
banks. In addition, the root of the lead situation. However, whether such a policy,
portion of the equation is explosive, and the which is more accounting-related in nature,
series is stable in the aggregate and therefore can address the real economic problems
does not predict immediate signs of spiraling associated with bank loans going bad is
out of control with the particular ARIMA another question. As this study shows, the
(1,0,1) specification during the decade of real and asymmetric information problems
‘emerging India’ reforms. associated with bad debt formation requires
The estimated equation is as follows: close attention.
The converged mean of this ratio is
ratio pt ¼  2:56 þ 0:94 ratio pt1 þ 0:93 ratio ptþ1
2.54 per cent, which, although not high
ð9:87Þ ð14:91Þ ð13:40Þ
in percentage terms, can primarily translate
into two implications. First, as the total
The graph of the predicted variable for advance is Rs 6061.51 billion in 2000,
the first 500 cases is given in Figure 7. the predicted NPAs would be around
Rs 153.96 billion, which comes to around
Rs 150 per capita. This figure is significant
CONCLUSION if confidence in the banking system is
Two significant tendencies emerge from the shaken somehow. Second, because according
above analysis. First, NPAs are significantly to the accounting system followed in
sticky over time. Second, larger NPAs are commercial banking this 2.54 per cent
associated with larger advances and vice- is a charge on profits, therefore assuming
versa. However, optimism can still prevail – rational decision making in the banking
NPAs are not spiraling out of control and are sector, interest rates charged can be expected
showing signs of a slight reduction. The to be inflated by at least this figure of
policy initiated during the 1990s of 2.54 per cent, which has its own spiraling
classifying bad debts as NPAs after two effects on growth.

68 & 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
Dynamics of emerging India’s banking sector assets

Thus, while financial policy attention of This issue requires further research in the
the government seems to be overtly fixed on future.
the stock market with the emerging markets The current banking crisis in a number of
regime, cumulative effects of history on the countries have parallels in the path, which
operation of the commercial banking system may be generated by the banking sector
require attention. This attention has to draw outlined in the article. For example, the
upon the interaction of the small and US bailout of defaulting banks’ assets,
medium scale business enterprises which as laid out in the Paulson Plan (BBC News
have no access to the stock market with the website, November 12, 2008), was an
commercial banks as well as the interaction acknowledgement of the fact that current
of the commercial banking sector with the bad assets were an outcome of past decisions
small and medium sector enterprises which and not a random event, and hence required
is the main customer base for commercial calculated state intervention. This path-
banking. This article finds that this dynamic dependant dynamic is, it is conjectured,
relationship is captured stably by regressing explainable by the dynamic approach of the
NPAs on themselves one period lagged, model in this article in terms of banking
compounded as a ratio with total loans and sector asset accumulation (and bad debts)
advances. A set of dynamic graphs help in over time. To what value the ratio_p would
visually understanding the dynamics of have converged in the long run in the US
entrepreneurship with banking companies case is beyond the scope of the simple model
and their dynamic impact on interest rates. in this article. However, it may be able to
Banking crises in emerging economies generate an alternative framework in terms
merit particular attention for two reasons: of partial nationalization of the infrastructural
(a) the serious consequences for local sector of banking, if it is shown to be
economies, and, (b) the fallout in other dynamically stable over time and thereby
countries as financial markets become more create good companies for this infrastructural
integrated (Goldstein and Turner, 1996). sector.
This article has identified a measure for
estimating dynamically the local impact as
mentioned in (a). Owing to its information ACKNOWLEDGEMENTS
content, simplicity, dynamic ability and The authors thank the Planning Commission
convergence with the large Indian data set, of India for financial support. This article has
post-privatization, the p-ratio is a robust benefited from comments by Kenneth West,
approach to measuring local impact. Frank Hahn, Darrell Duffie, A. Zaman,
It would, also, perhaps not be too casual M.Gittleman, A. Vinay Kumar, and a referee
a generalization to suggest that the and participants at an International
integration of control over NPAs of banks Conference on Entrepreneurial & Small
and the size of the corresponding loans and Business Finance 2006 at IIM Lucknow. The
advances (Figure 3) ought to bear a direct usual disclaimer applies.
relationship – which means that larger loans
ought to be monitored ‘more’ with respect
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