The tide of bank non-performing assets (NPAs) seems to be finally ebbing, with net reported NPAs coming below 2%. Measures ranging from asset quality review to the introduction of a modern bankruptcy code were implemented to fight the crisis. But what actually led to the reversal of the NPA wave?
In a July 2022 working paper, Nishant Kashyap, Sriniwas Mahapatro and I study the impact of the three waves of mergers of public sector banks (PSBs) on bank NPAs. The mergers were found to have resulted in a near 10% reduction in NPAs of weak merging banks, and almost all the decline is due to a decrease in strategic defaults. To appreciate the link between bank mergers and improvement in loan performance, it is important to understand the idea of ‘borrower runs’.
‘Borrower run’ is a phenomenon where borrowers strategically default on banks that are expected to fail as they do not expect such banks to be in a position to lend in the future. A 2007 study by Philip Bond and Ashok Rai points out that deterioration in bank health can cause a ‘run’ of the borrowers.
To fix ideas, consider an economic environment where the primary motivation for loan repayment is the hope that it will lead to the granting of bigger loans in the future. Typically, in countries with weak contract enforcement, the hope of accessing future loans mostly drives loan repayment discipline. Suppose borrowers think that other borrowers are likely to default and the bank will eventually collapse. Then the hope of receiving loans in the future will naturally recede. In such circumstances, many borrowers are likely to default even when they have the capacity to repay. Such defaults can take the form of a run where expectations of some borrowers defaulting can fuel defaults on a large scale and lead to the eventual collapse of banks.
In their 2016 study Fabio Schiantarelli, Massimiliano Stacchini and Philip E Strahan detect borrower runs in Italy. In another 2021 paper, Kashyap, Mahapatro and I replicate their result and show that borrower runs exist even in India.
Mergers were designed so that a larger, and typically healthier, bank acquired one or more weak and small banks. For example, which had a low NPA of 3.5% and high capital adequacy ratio (CAR) of 14.5%, acquired Allahabad Bank with an NPA and CAR of 6% and 10.9%. The amalgamated entity ended up having an NPA of 4.6% and CAR of 13%. This strategy ensured that the merged entities started with a high lending capacity, together with the better management capabilities of the acquirer.
Given the low chance of failure of larger banks, it is now reasonable for borrowers to expect that the flow of credit will continue in the future. Thus, the incentive to default strategically, expecting curtailment of credit in the end, reduces after the merger. So, even without any improvement in the inherent health of borrowers, loan repayment discipline can improve with the merger of weak banks with stronger banks.
Some key features emerge in this reversal of the borrower-run thesis:
Improvement in loan performance is stronger in regions where contract enforcement is weak. These are regions where borrowers have a maximum incentive to run, hence, fertile grounds for reversal of runs.
Improvement in loan performance is driven by borrowers of weak merging banks, not those of stronger banks.
There is no association between measures of borrower health and reduction in NPAs. Thus, it is not the case that borrowers suddenly become healthy after their bank merges with a stronger bank and, hence, reduces defaults.
Borrowers of weak banks that merged receive more bank credit after the merger.
Improvement in loan performance and post-merger reduction in loan defaults have significant macroeconomic consequences. The overall credit flow to districts dominated by the weak banks that merged increases. The value of active projects – ongoing projects minus stalled projects – also increases substantially.
The reduction in NPAs in India is not only due to bank mergers. Recent research on Indian banking suggests that several other regulatory and government interventions also played a role. But the merger of weak banks with relatively stronger banks did play an important role in stemming strategic defaults.
