India’s banking sector has grappled with the challenge of non-performing assets for more than a decade and a half. While the NPA position of banks has improved to some extent, the latest financial stability report by the Reserve Bank of India projects a potential rise in the share of bad loans. It also raises concerns about the deteriorating asset quality of unsecured retail loans and flags risks in the retail lending portfolios of small finance banks.
The NPA ratio has seen a consistent decline since peaking in June 2018. This improvement can be attributed to the better financial position of lenders, characterised by the sustained expansion in assets and deposits. Banks’ continued focus on cleaning up their books has brought gross bad loan ratios to their lowest levels in 13 years.
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However, the RBI report reveals that loan write-offs were a significant factor in the reduction of NPAs in the first half of the current financial year. While write-offs remove bad loans from a bank’s books, they do not address underlying issues such as poor lending practices. This approach masks systemic vulnerabilities, reduces available capital, hampers lending capacity, and affects profitability, paving the way for future defaults. A stronger focus on recoveries and the upgradation of loan accounts is crucial for sustainable improvement.
Systemic weaknesses in PSU banks
Despite NPAs falling to their lowest level in more than a decade, early warning indicators suggest potential stress in certain sectors. Public sector banks are particularly vulnerable due to their higher exposure to priority sectors such as agriculture and large-scale manufacturing. These sectors are inherently riskier and often subject to political sensitivities. PSBs also face pressure to lend to specific sectors or borrowers, even when credit risks are high.
In contrast, private banks have diversified their focus toward retail lending and small businesses, which carry lower default risks. Nonetheless, the manufacturing sector remains a significant contributor to NPAs, especially for PSBs. High-profile defaults by large corporations, such as Bhushan Power and Steel (over Rs 41,400 crore) and KSK Mahanadi Power Company (over Rs 21,390 crore), highlight weaknesses in risk assessment, project execution, and recovery mechanisms.
Addressing these systemic weaknesses requires continued reforms and the strengthening of risk management frameworks in the public banking sector.
Retail loans and small finance banks
The banking sector is not yet out of the woods. According to the RBI report, gross NPAs could rise to 3% by March 2026 under a baseline scenario that considers risks such as credit quality deterioration, fluctuating interest rates, and global geopolitical uncertainties.
Small finance banks are particularly vulnerable, with their retail loan portfolios showing increasing signs of stress. A significant portion of the newly identified NPAs originates from unsecured loans, which account for 51.9% of total bad loans in this segment. The interconnectedness of a borrower’s portfolio means that defaults on smaller unsecured loans, such as personal loans, can cascade into larger, more secured loans, amplifying risks.
Global lessons in NPA management
International experiences offer valuable insights into managing NPAs. In the United States and the European Union, stringent regulations compel banks to promptly identify and address bad loans. Regular audits and stress tests ensure that banks remain vigilant and proactively mitigate risks, enhancing overall stability.
Many countries have also established specialised Asset Management Companies (AMCs) to handle NPAs. For instance, South Korea’s Korea Asset Management Corporation (KAMCO) and Malaysia’s Danaharta have successfully reduced NPAs by purchasing distressed loans and restructuring them. These AMCs allow banks to focus on core activities while experts manage bad assets.
Way ahead for India
India’s progress in addressing NPAs is evident, but resolving the issue requires a multi-faceted approach:
Strengthening the Insolvency and Bankruptcy Code: Expediting recoveries through the IBC can enhance creditor confidence.
Improving risk assessment practices: Banks must adopt more robust mechanisms to evaluate and mitigate risks.
Greater accountability in write-offs: Transparency in loan write-offs and a concerted effort to recover dues from large defaulters are essential.
Targeted policy measures: Sectors like agriculture and MSMEs require better price stabilisation, timely payments, and credit guarantees.
Governance challenges in PSU banks
A 2018 RBI report highlighted that PSU banks, despite holding only 65% of overall credit, accounted for over 85% of reported frauds. This disproportionate figure points to governance challenges, including lax lending practices and weak internal controls.
To address these issues, PSU banks must prioritise stricter credit discipline and enhance project monitoring mechanisms. Operational autonomy and changes in government ownership structures could further strengthen their resilience. Without such reforms, future crises may become inevitable.
India’s banking sector has made commendable progress in tackling NPAs, but structural challenges persist. To secure a stable and resilient banking system, policymakers and regulators must adopt a proactive, comprehensive approach. Strengthened governance, targeted reforms, and lessons from global best practices can help India’s banks build a foundation for sustainable growth while safeguarding against future crises.