Asset quality determinants of Indian banks: Empirical evidence and policy issues

• Author: Varun Dawar,Debasish Maitra,Rakesh Arrawatia,Saumya Ranjan Dash
• Published date: 01 November 2019
• DOI: http://doi.org/10.1002/pa.1937
• Date: 01 November 2019

PRACTITIONER PAPER

Asset quality determinants of Indian banks: Empirical evidence

and policy issues

Rakesh Arrawatia

1

|Varun Dawar

2

|Debasish Maitra

3

|Saumya Ranjan Dash

3

1

Department of Finance, Institute of Rural

Management Anand, Anand, India

2

Department of Financial Studies, University

of Delhi, New Delhi, India

3

Department of Accounting and Finance,

Indian Institute of Management Indore (IIM

Indore), Indore, India

Correspondence

Rakesh Arrawatia, Department of Finance,

Institute of Rural Management Anand,

Anand‐388001 Gujarat, India.

Email: rarrawatia@irma.ac

The Indian banking industry has been suffering from a huge number of nonperform-

ing loans, and the loan asset quality has been deteriorated over the years. This has led

to significant capital erosion of many banks in India. The surge in corporate defaults

leading to an enormous rise in nonperforming loan assets has been impairing the per-

formance of Indian banking industry in particular and economic growth in general.

Hence, it is intuitive to ask what are the determinants of poor asset quality of Indian

banks. To answer this question, using a sample of 47 commercial banks over a sample

period of 2000 to 2014, our study examines the bank‐, industry‐, and macroeco-

nomic‐specific determinants of asset quality of Indian banks. Our empirical analysis

also accommodates the impact of different ownership structures (public and private

sector) and the impact of financial crisis while analysing the determinants of poor

asset quality of Indian commercial banks. Results reveal that bank‐, industry‐, and

macroeconomic‐specific factors are responsible for the burgeoning nonperforming

loan assets of Indian commercial banks. The results are qualitatively similar across

different ownership structures. The findings suggest that forecasting models for non-

performing assets should also consider macroecomomic‐and industry‐specific factors

along with the bank‐specific factors.

1|INTRODUCTION

The stability of banking system with sound loan asset quality serves as

an important tool for capital allocation, stability of financial system,

financial deepening, macroprudential surveillance, and economic

development. A growing share of nonperforming loans (NPLs, hereaf-

ter) in the loan portfolio of banks signifies greater risks for banking

stability (Ghosh, 2015). In light of the potential macroeconomic impair-

ment caused by deteriorating asset quality, understanding factors that

influence NPLs can have significant policy implications. Recent litera-

ture following the financial accelerator theory argument (Bernanke &

Gertler, 1989; Kiyotaki & Moore, 1997) supports the fact that both

bank‐and macroeconomic‐specific indicators are essential determi-

nants of loan asset quality (Alhassan, 2014; Banerjee & Velamuri,

2015; Chavan & Gambacorta, 2016; Ghosh, 2015; Louzis, Vouldis, &

Metaxas, 2012; Rajan & Dhal, 2003). However, there is admittedly

limited evidence available from India on the bank‐, industry‐,

ownership‐, and macroeconomic‐specific determinants of asset quality.

Our paper extends the related literature by examining the determinants

of NPLs using the data from Indian banks. We focus on Indian banking

sector to carry out our empirical examination because not only it is one

of the most important developing economies in the world but also it has

a rich history of varying types of banking sector controls and reform

(Ahamed, 2017; Banerjee & Velamuri, 2015; Demetriades & Luintel,

1996; Nidugala & Pant, 2017). Our empirical analysis focuses on sample

period 2000 to 2014 and accounts for more than 90% of total assets of

Indian banking sector (using data from 27 state‐owned banks and 20

privately owned banks). We use system GMM (Arellano & Bond,

1991) based dynamic panel models to carry out empirical analysis.

There are four issues that motivate us to carry out this research.

First, Indian financial system is predominately a bank‐centric financial

sector (Sahoo, 2014) with banks accounting for the largest share of

total financial assets and being closely interlinked with other constitu-

ents of the financial system (Chavan & Gambacorta, 2016). In recent

years, a high level of impaired loans and weak capital position under-

mine the overall credit profile of India's banking system. Appendix A

Received: 16 February 2019 Accepted: 23 February 2019

DOI: 10.1002/pa.1937

J Public Affairs. 2019;19:e1937.

https://doi.org/10.1002/pa.1937

© 2019 John Wiley & Sons, Ltd.

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