Asset Quality Review and its impact on banks

July 17, 2016 11:10 pm | Updated November 17, 2021 02:37 am IST

The Reserve Bank of India (RBI) has conducted an asset quality review with a view to cleaning up balance sheets of banks. This has resulted in mounting losses for the banking sector. Here is an explainer on the AQR, why it was required, and the road ahead:

What is an AQR?

Typically, Reserve Bank of India (RBI) inspectors check bank books every year as part of its annual financial inspection (AFI) process. However, a special inspection was conducted in 2015-16 in the August-November period. This was named as Asset Quality Review (AQR). In a routine AFI, a small sample of loans is inspected to check if asset classification was in line with the loan repayment and if banks have made provisions adequately.

However, in the AQR, the sample size was much bigger and in fact, most of the large borrower accounts were inspected to check if classification was in line with prudential norms. Some reports suggest that a list of close to 200 accounts was identified, which the banks were asked to treat as non-performing. Banks were given two quarters, October-December and January-March of 2016 to complete the asset classification.

Why was it necessary?

The RBI believed that asset classification was not being done properly and that banks were resorting to ever-greening of accounts. Banks were postponing bad-loan classification and deferring the inevitable. “At the Reserve Bank, corporations and banks come to us saying: ‘Give us some forbearance. Don’t call our loans bad even if it has not been paid for three years. Allow us to postpone recognition.’ This is a wrong way to go about it,” RBI governor Raghuram Rajan had once said. Mr. Rajan had also said ‘band-aids’ would no longer work and banks need deep surgery.

Investors were also facing uncertainties as guidance by banks on bad loans was erratic. So finally, Mr. Rajan decided to end the uncertainty as he committed to cleaning up bank balance sheets by March 2017.

What is its impact?

The AQR created havoc on banks’ profit & loss accounts as many large lenders slipped into losses in both the said quarters, which resulted in some of them reporting losses for the full financial year. Record losses were posted in Q4 of FY16 by many large lenders like Bank of Baroda (Rs.3,230 crore), Punjab National Bank (Rs.5,367 crore), IDBI Bank (Rs.1,376 crore) – to name a few.

Almost all public sector banks were impacted, while the impact in the private sector was limited to biggies such as ICICI Bank and Axis Bank. HDFC Bank – the second-largest private sector lender – emerged unscathed from the crisis as its exposure to big-ticket infrastructure projects was relatively small.

Bad loans in the Indian banking system jumped 80 per cent in FY16, according to RBI data, mainly on account of the AQR.

Is there more pain to come?

The impact of the AQR is not over. In the last two quarters of the previous financial year, banks have classified AQR-identified accounts (which were termed as stressed assets) as NPAs which resulted in an increase in provisioning, to 15 per cent as compared to 0.4 per cent provisioning requirement for standard assets.

In the four quarters of the current financial year, banks have to increase provisioning of accounts that were restructured (known as standard restructured assets, and which attract 5 per cent provisioning) earlier but are still weak (that is, repayment is not regular) – to 15 per cent over the four quarters, but are not mandated to classify them as NPA. Accounts that were classified as sub-standard (first category of NPA), will slip into doubtful category if it stayed sub-standard for 12 months.

Doubtful assets attract 40 per cent provisioning. Further down the line, if loan is not serviced, banks have to treat it as a loss account with 100 per cent provisioning.

Will there be more AQRs?

It is unlikely that such stringent asset quality reviews will take place further. RBI has said that it does not intend to make the AQR an annual or a frequent exercise.

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