Asset Quality and Profitability of Public Sector Banks (PSBs)

The Tale of Indian PSBs — Non-Performing Assets and Capital Erosion

The collapse of a PSB as a consequence of the NPA crisis could have devastating economic ramifications. The government is hence committed to addressing the issue — palliatively at the least. Capital Infusion has been one of the primary (palliative) solutions that the government has implemented to address this situation, wherein the government invests additional capital in the PSBs to bolster equity.

In most cases, the money for investing in equity does not directly come from the government’s coffers, but instead comes from the banks themselves. To achieve this, PSBs use their deposits to subscribe to non-transferable, HTM (held to maturity) recapitalisation bonds floated by the government. The capital raised from these bonds is in turn invested in the banks as equity, by the government. This enables the PSBs to move some of their deposits (liabilities) to low-risk assets (technically government bonds) and equity. The increase in equity implies that banks can expand their lending activities while remaining within the RBI stipulated capital requirement of 8% Capital to Risk Assets Ratio (CRAR). Ideally, the increased lending activities of PSBs should result in higher dividends and yields to the government, which would eventually be used to pay off the bonds.

In the 2021–22 budget speech, the Finance Minister proposed an additional ₹200 billion to be infused into the PSBs to ensure that they meet the capital requirements (8% CRAR), and for enabling them to expand their lending activities.

Measurement — Keeping a Check on Moral Hazard

To this end, I constructed a non-parametric asset quality index and profitability index using Principal Component Analysis (PCA), to rank PSBs along these two dimensions. The PCA based indices are constructed using data of indicators reported as of 30th September 2020, which are provided by the RBI in their ‘Database of Indian Economy’ portal. I restrict the indicators to only reflect domestic operations as not all PSBs have a comparable global presence. The list of indicators used for profitability and asset quality are listed in Table 1. (See the appendix for more details on the PCA methodology).

The Results — Signs of Clustering

The results clearly indicate that SBI is the best performing bank in terms of both asset quality and profitability.

Punjab National Bank, Union Bank of India, and Bank of Baroda are closely clustered at a distant second place. Indian Bank, Bank of India, and Canara Bank are clustered at third place.

Indian Overseas Bank, Bank of Maharashtra, Central Bank of India, and UCO Bank are clustered at fourth place. Punjab and Sindh Bank is a distant last in the ranking.

It is important to note that despite the recent bank amalgamations, PNB, BoB, and Union Bank are still in the second position.

Which cluster(s) of PSBs truly deserve further capital infusion, have some failed to demonstrate improvement?

How does the Ranking System help?

From a management perspective, the understanding of relative positions of the PSBs could enable the RBI and the government to understand best practices of the more successful banks, which could then be replicated by other banks.

The Road Ahead

Author: Akshay Natteri Mangadu

Originally Published on February 2, 2021, on LinkedIn.

Appendix — PCA Methodology

Applied Econometrician (M.A. from University of Chicago)