Nonperforming loan auction: Prudent policy response or earnings management?

• DOI: http://doi.org/10.1002/pa.1936
• Author: Ashish Pandey,Kousik Guhathakurta
• Date: 01 November 2019
• Published date: 01 November 2019

ACADEMIC PAPER

Nonperforming loan auction: Prudent policy response or

earnings management?

Ashish Pandey |Kousik Guhathakurta

Finance and Accounting Area, Indian Institute

of Management, Indore, India

Correspondence

Ashish Pandey, Finance and Accounting Area,

Indian Institute of Management, Indore, India.

Email: fi16ashishp@iimidr.ac.in

The use of asset management companies is one of the standard policy prescriptions

for the resolution of the banking crisis. In this paper, we investigate whether banks

use the sale of nonperforming loans to asset management companies to exploit the

accounting guidelines and manage their reported earnings. Using nonperforming

loans sale data of Indian banks, we examine the role of income smoothing, regulatory

capital compliance, and ownership concentration in cherry‐picking nonperforming

loans offered for sale. We report evidence that the above considerations dissimilarly

affect selective identification of nonperforming loans. Our results show that banks

with below average return on assets, banks with below average capital ratio, and

banks with a significant government ownership engage in selective identification of

nonperforming loans offered for sale.

1|INTRODUCTION

The use of asset management companies (AMC), organisations

established with the specific purpose of resolving nonperforming loans

(NPL) transferred from banks, is one of the standard policy prescrip-

tions for the resolution of the banking crisis (Campbell, 2007;

Claessens, Djankov, & Klingebiel, 2001; Haley, 2000; Klingebiel,

2000; Mako, 2001). Hryckiewicz (2014) reports the intervention of

AMC in 62 instances across 25 countries. Despite the frequent use

of AMC to address the banking crisis, their effectiveness is question-

able at best based on the cross‐country evidence. Numerous studies

have empirically presented the inability of AMC in achieving their

stated objectives (Dziobek & Pazarbasioglu, 1997; Klingebiel, 2000;

Campbell, 2007; Hoshi & Kashyap, 2010; Osuji, 2012; Laeven &

Valencia, 2012). In this paper, we examine whether banks use the sale

of NPLs to AMC for motives other than risk minimisation and prudent

capital management.

An increase in the corporate debt and higher default rates have

resulted in a high amount of NPL in the Indian financial system. The

use of AMC to tackle growing NPL problem has been a common prac-

tice in the recent time in India (Narang & Kaveri, 2016; Tiwari, 2011).

The Reserve Bank of India (RBI), a monetary authority and the banking

regulator, has intervened by mandating stricter provisioning require-

ments under its asset quality review guidelines forcing banks to

acknowledge the problem rather than relying upon unviable

restructuring and other mechanisms to delay the loss recognition.

The federal government of India has a majority ownership in a large

number of banks, and such banks are commonly referred to as public

sector banks (PSB). The increase in distressed assets and the resultant

impact on regulatory capital ratios are more pronounced for PSB as

compared with private banks. The ratio of gross stressed loans to total

loans was 19.1% for PSB as compared with 6.4% for private banks as

of March 2017 (RBI Statistical Tables, 2017). The increase in NPL has

led to the deterioration in the regulatory capital ratios, has forced PSB

to reduce lending, and has resulted in the subdued transmission of the

expansive monetary policy. The federal government, in October 2017,

was forced to announce an infusion of approximately USD 32.5 trillion

of additional capital over the next 2 years in PSB, which are likely to

incur a significant loss on NPL stuck in insolvency proceedings.

Using NPL sale data of Indian banks, we consider the possibility

whether banks exploit the accounting guidelines prescribed by bank-

ing regulator for NPL sale. A significant increase in the NPL sale activ-

ity to AMC in the recent years, the existence of government‐

controlled banks, large equity ownership of PSB in certain AMC, and

fragile regulatory capital situation of PSB offer an interesting dimen-

sion to situs of our study. We examine if banks use NPL sale to

AMC as a tool for earnings management instead of a mechanism for

This paper is an extended and revised version of a preliminary conference report that was

presented at the 7th India Finance Conference, IIM Bangalore, December 20–22, 2017.

Received: 28 January 2019 Accepted: 23 February 2019

DOI: 10.1002/pa.1936

J Public Affairs. 2019;19:e1936.

https://doi.org/10.1002/pa.1936

© 2019 John Wiley & Sons, Ltd.

wileyonlinelibrary.com/journal/pa 1of10