Original Article

Dynamics of emerging India’s

banking sector assets: A simple
model
Received (in revised form): 17th February 2009

Soumitra K. Mallick
is Associate Professor at the Indian Institute of Social Welfare & Business Management, Management House, College Square
West, Kolkata, India. He holds a BCom (Hons) from St.Xavier’s College, University of Calcutta; and a CA from the Institute of
Chartered Accountants of India and a PhD from Department of Economics, New York University.

Amitava Sarkar
is Professor and Director of the School of Business Management, West Bengal University of Technology, Salt Lake, Kolkata, India.
He holds an MA in Economics from the University of Calcutta and a PhD from the Department of Economics, University of
Pittsburgh.

Kalyan K. Roy
is Professor and Head, MBA department at the Indian Institute of Social Welfare & Business Management, Management House,
College Square West, Kolkata, India. He holds a BE degree from Bengal Engineering College, University of Calcutta and a PhD
degree from the Graduate School of Business, University of South Carolina.

Tamal Duttachaudhuri
is Chief General Manager, Industrial Investment Bank of India, Kolkata, India. He holds a MA degree from the Department of
Economics, University of Calcutta and a PhD degree from the Department of Economics, Johns Hopkins University.

Anjan Chakrabarti
is Professor, Department of Economics, Calcutta University, Kolkata, India. He holds a MA degree from the Department of
Economics, University of Calcutta and a PhD from the Department of Economics, University of Southern California.

Correspondence: Soumitra K. Mallick, Indian Institute of Social Welfare & Business Management, Management House, College
Square West, Kolkata 700 073, India
E-mail: smallick@iiswbm.edu

ABSTRACT Banking sector loans are the principal source of capital for small and
medium business ventures in India, comprising firms that are not large enough to be
registered with stock exchanges. Non-performing assets (NPAs) are an important measure
of the success of these businesses, as well as of their levels of discretion in carrying out
their commercial activities conditional on their role in developing India’s entrepreneurship
outside the stock markets. In this article we analyze certain properties of NPAs in Indian
Banks over the 1990s, when liberalization was introduced by opening up a significant
portion of the public sector, allowing private banks to do business. We arrive at three
conclusions for emerging India’s banking sector. First, NPAs (as a ratio of loans and
advances) are significantly sticky over time. Second, larger NPAs are associated with larger
advances and vice-versa. Third, NPAs do not seem to have spiraled out of control over the

& 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
www.palgrave-journals.com/jam/
 Dynamics of emerging India’s banking sector assets

1990s. A simple cointegration test is carried out and a set of dynamic graphs, using notions
of ‘fibration’, is presented to support the results.
Journal of Asset Management (2010) 11, 62–70. doi:10.1057/jam.2010.1

Keywords: banking sector in emerging economies; dynamics; cointegration;

non-performing assets; ratio_p

INTRODUCTION Allen and Gale (2000), Kaminsky and

Banking sector loans are the principal source
of capital for small and medium business
ventures in India, comprising firms that are
not large enough to be registered with stock
exchanges. Non-performing assets (NPAs) or
loans and advances that have defaulted on
their installment payments for two or more
quarters are an important measure of the
success of these businesses, as well as of their
discretion in carrying out their commercial
activities conditional on their role in
developing India’s entrepreneurship
outside the stock markets. This article
analyzes the beneficial impact of a
well-functioning banking sector on the
real sector through developing small and
medium businesses outside the stock
markets in India.
There are two aspects to the analysis. One
is the importance of the banking sector in
the development of small- and medium-sized
businesses, and the other is the development
of commercial banking itself through these
businesses. With the liberalization of the
capital market, which includes the
privatization of the public sector carried out
in the 1990s, the entry of private commercial
banks as well as the increase in commercial
business as part of the overall portfolio of
public sector banks made it necessary to take
stock of how the Indian banking sector fared
over the decade. This forms a measure of the
success or failure of commercial banking in
emerging markets such as India. The
interdependence between the two sets of
factors has the potential to make the NPA
values follow a complex dynamic series,
which needs to be modeled and analyzed.
Reinhart (1999, 1996), Kiyotaki and Moore
(1997), Stiglitz and Weiss (1981) and others
have examined the factors that make the
banking sector particularly fragile. The
existing literature has expressed concern over
the inherent tendencies in the banking sector
towards strength, arising out of institutional
characteristics with respect to norms/rules
and inadequate controls endemic to
emerging market economies characterized
by incomplete asset markets (Geanakoplos
and Polemarchakis, 1986; Mallick, 1993,
2006, 2007; Sarkar et al, 2001). A study of
such strength is therefore important, as is
the development of a measure to study
such strength. To bring out the dynamic
relationship, we discuss the historical values
of NPAs as explanatory values for current
NPAs in order to form a model for
forecasting future NPAs, and hence the
strength of the banking system in the case
of the emerging Indian market. This is a
simple approach, but as the analysis will
show it is a good model for the future
course of NPAs in the Indian banking
system as a whole.
Our empirical analysis brings out three
significant tendencies. First, NPAs (as a ratio
of loans and advances) are significantly
sticky over time. Second, larger NPAs
are associated with larger advances and
vice-versa. Third, NPAs do not seem to be
spiraling out of control; rather they are
showing signs of a slight reduction. The third
result throws positive light on a particular
aspect of commercial banking policy
followed by the Finance Ministry of India.
The policy initiated during the 1990s of

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 Mallick et al
classifying bad debts as NPAs after two
installment defaults seems to have brought
the bad debt situation under control.
However, this study shows that the real and
asymmetric information problems associated
with bad debt formation requires serious
attention, as the dynamically stable value is
significantly non-zero.
The article is organized as follows. In
the next section we discuss the outline of the
model used for analysis. We then discuss
the data set, followed by the cointegration
test using a time series ARIMA (1,0,1)
Maximum Likelihood analysis linked with
the graphical analysis with the data set and
the results. The last section concludes.
THE MODEL
Since the nationalization of the late 1960s
and early 1980s, the banking sector in India
has been largely state-owned, in the form
of nationalized banks. As, until recently,
shares of nationalized banks in India were not
traded in the stock market, the financial
performance of banks is to be measured with
respect to different criteria from those of
companies listed on the stock exchange. In
addition, banking companies, being financial
institutions, belong to a different industrial
sector, and hence measures of performance
have to differ. Similar discussions on the
economics of banking can be found in such
sources as Gurley and Shaw (1960) and
Bagchi (1997).
The purpose of this study is to assess the
extent of financial strength in the banking
system over the period covering the 1980s
and the 1990s. This period witnessed
significant structural change, involving the
opening up of the stock markets and the
trading of portions of shares of certain
nationalized banks, notably the State Bank
of India, in the stock market. However,
as the significant nature of operations of the
banks remains the inflow and outflow of
credit through the mechanism of interest
rates (that is, commercial banking), the
64 & 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
financial performance of banks has to be
measured in terms of the efficient intake
and maturity of deposits and efficient
provision and recovery of loans and advances.
The two essential variables in this circulation
mechanism are interest and bad debts.
Interest received on loans and advances
forms the major part of the income of the
banking sector, while interest paid and bad
debts (technically renamed non-performing
assets) form the major part of the costs of
the banking sector. When comparing
nationalized and private banks, as will be
discussed in detail in the data section, it is
evident that NPAs are a formidable
problem for nationalized banks as opposed
to private banks. However, as nationalized
banks constitute a major portion of the
banking sector’s total deposits, as well as
loans and advances, because of its historical
priority on small savings and prioritized
lending, NPAs are a significant barrier to
the efficient functioning of the banking
sector as a whole and a key factor in the
financial strength of the banking system.
Explanations for the level of NPAs are
not hard to find. To a large extent, as is the
case with any industry, bad debts arise as a
result of an inefficient system of management
and recovery of debt, along with the real
economic causes of business failure. When
applied to the banking sector, lending gets
coupled with bad debts as a possible
explanation for the incidence of NPA costs.
Thus, lending to bad-quality projects in
terms of both technology and risk;
asymmetric information giving rise to
imperfect screening and monitoring that
results in adverse selection of projects and
terms of lending; and moral hazard in the
monitoring and recovery of loans (Stiglitz
and Weiss, 1981) lead to the high incidence
of NPA costs. According to the definition
of NPAs given by the Reserve Bank of India,
these are loans and advances on which
interest payment is in default for more than
two quarters. Hence, they include not only
bad debts, but also other loans and advances
 Dynamics of emerging India’s banking sector assets

that fall into the risky category with respect 1800

to debt servicing. Thus, the broad definition 1400

of risk assets in the adverse selection and
moral hazard literature more or less coincides 1000

BDEBTS
with the definition of NPAs. 600
An interpretation of the asymmetric
information literature as discussed above can 200
proceed as follows. Banks that have lent in
-200
the past to high-default risk firms for priority 0.5 1.5 2.5 3.5 4.5 5.5 6.5
reasons or reasons related to adverse selection TIME

and moral hazards find it difficult to recover Figure 1: Bad debts over time (annual).
interest income and principal. This reduces
the debt-service-coverage-ratio of bank
deposits, thereby inducing them to lend to 180

higher-return, higher-risk customers. 140

Owing to the dynamic operation of the
adverse selection and moral hazard problems 100

this accumulates further NPAs. By this RATIO_P

60
argument, the aggregate implication is that
NPAs give rise to further NPAs in the Indian 20
banking sector. In this article, we pursue this
-20
line of reasoning to test the time series 0.5 1.5 2.5 3.5 4.5 5.5 6.5
properties of NPAs. Hence, as will be seen, TIME

NPAs expressed as a function of outstanding Figure 2: Ratio-p over time (annual).

loans and advances are self-driven over time,
and this stickiness has given rise to a vicious
cycle of bad debts in the banking sector,
which makes the entire financial system
fragile by impeding the operation of the
multiplier.
THE DATA SET
The data set comprises the period 1995–
2000, for which full data are available in the
Prowess database of the Centre for
Monitoring Indian Economy, and consists of
a maximum of 188 banking companies in
1998 and a minimum of 121 banking
companies in 1995. The variables that are
considered for the purpose of this study are as
follows: provision for bad debts (NPA) for
the year, closing balance of loans and
advances, and the year of operation. With
these variables, we construct a composite
variable 100  bad debts/loans and
advances ¼ ratio_p to express bad debts as a
function of loans and advances. As discussed
in the previous section, bad debts and NPAs
will be used interchangeably. The graphs of
the variables are given in Figure 1, which
describes the plot of the bad debts (NPAs)
over time ranging from first half of 1995 to
second half of 2000. Figure 2 describes the
plot of the NPAs to loans and advances ratio
(ratio_p) over time. Figure 3 describes the
plot of Bad Debts against advances. This
shows a significant clustering at small
advances and low bad debt levels. In
addition, there seems to be a linear trend,
which we estimate in the next section.
Figure 4 describes the plot of ratio_p against
advances. This again shows a significant
clustering close to the origin. Furthermore,
there seems to be a constant relation across
levels of advances. Figures 5 and 6 are
three-dimensional graphs, plotting the Bad
Debts and the ratio_p against advances and
across time. This dynamic ‘fibration’
technique used in the graphical analysis of

& 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70 65
 Mallick et al

time series helps in analyzing the time (see, for example, Granger and Newbold,
dimensional that represents structural 1977; Rao, 2000). While a clear picture does
parameters, essential in cointegration tests not seem to emerge graphically, a clustering
of points at the low advance–low bad debt
and low bad debt–advance ratio levels are
1800 clearly discernible over all the frames. How
1400
these relations change (or remain sticky)
over time is analyzed in the Maximum
1000 Likelihood estimation in the next section.
BDEBTS

600

200 TIME SERIES RESULTS

-200
-10000 10000 30000 50000 70000 90000
ADVANCES
Figure 3: Bad debts vs. Advances (scaled).
The ARIMA (1,0,1) results of the single
1.1e5 series (ratio_p) time series are presented in
Table 1. The ratio_p variable is regressed on
itself 1 period lagged and 1 period led. The
model is of the following nature:

110 ratio pt ¼A þ B1 ratio pt1 þ B2 ratio ptþ1

90 þ ~et ; ~et  Nð0; s2e; t Þ
70
RATIO_P

The motivation for using a mixed lag-lead

50
model (ARMA model) to estimate the
30 outcomes of investment behavior in
10 contingent commodity models has been
analyzed theoretically to some extent in
-10
-10000 10000 30000 50000 70000 90000 1.1e5 Mallick (1993, 2006, 2007). Mispricing of
ADVANCES assets in the sense of market failure has been
Figure 4: Ratio-p vs. Advances (scaled). shown to be a distinct possibility in such

Figure 5: Bad debts vs. Advances (scaled).

66 & 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
 Dynamics of emerging India’s banking sector assets

Figure 6: Ratio-p vs. Advances over time (scaled).

Table 1: Model: (1,0,1) MS residual=40.730

Parameter Asympt. Asympt. p Lower Upper
SE t ( 914) 95% Conf 95% Conf

Constant 2.564742 0.259974 9.86537 0.000000 2.054526 3.074958

pt1 0.941871 0.063173 14.90940 0.000000 0.817890 1.065852
pt þ 1 0.928103 0.069250 13.40221 0.000000 0.792195 1.064010

Table 2: Parameter covariances model: (1,0,1) MS Table 3: Parameter correlations model: (1,0,1) MS
residual=40.730 residual=40.730
Constant pt1 pt þ 1 Constant pt1 pt þ 1

Constant 0.067587 0.004796 0.000373 Constant 1.000000 0.291996 0.020696

pt1 0.004796 0.003991 0.004306 pt1 0.291996 1.000000 0.984292
pt þ 1 0.000373 0.004306 0.004796 pt þ 1 0.020696 0.984292 1.000000

cases. However, initial assumptions on of 0.94 and the pt þ 1 coefficient

history are shown to be necessary conditions
in analyzing such equilibrium. This is why
the constant intercept is necessary. Unlike
Mallick, we consider the Integral Process to
be trivial.
The parameters of the model are
estimated using the maximum likelihood
estimation procedure (Tables 2 and 3).
As is evident from the graphical analysis,
the time series shows a significant secular
trend and a significant intercept. The pt1
coefficient (autoregressive) takes on a value
(autoregressive) is 0.93. Both these estimates,
along with the negative constant, ensure
the prediction of stability in the long run.
Thus, the ratio of NPAs to Total Loans and
Advances can be taken to be constant in
the short run. The inference that directly
follows is that greater values of advances are
likely to be associated with greater default,
while smaller advances are less likely to
be in default.
There is a significant constant intercept of
–2.6, thereby signifying a reduction in the

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 Mallick et al
120
100
80
60
40
20
0 0
-20
-100 0 100 200 300 400 500
Observed
Figure 7: Ratio-p vs. no. of observation (scaled).
bad debt problem that does not change over
time with the volume of advances by the
banks. In addition, the root of the lead
portion of the equation is explosive, and the
series is stable in the aggregate and therefore
does not predict immediate signs of spiraling
out of control with the particular ARIMA
(1,0,1) specification during the decade of
‘emerging India’ reforms.
The estimated equation is as follows:
ratio pt ¼  2:56 þ 0:94 ratio pt1 þ 0:93 ratio ptþ1
ð9:87Þ ð14:91Þ ð13:40Þ
The graph of the predicted variable for
the first 500 cases is given in Figure 7.
CONCLUSION
Two significant tendencies emerge from the
above analysis. First, NPAs are significantly
sticky over time. Second, larger NPAs are
associated with larger advances and vice-
versa. However, optimism can still prevail –
NPAs are not spiraling out of control and are
showing signs of a slight reduction. The
policy initiated during the 1990s of
classifying bad debts as NPAs after two
68 & 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
Input: RATIO_P
120
100
80
60
40
20
-20
600 700 800 900 1000 1100 1200 1300 1400 1500
Forecast ± 90.0000%
instalments’ default seems to have brought
some amount of control to the bad debt
situation. However, whether such a policy,
which is more accounting-related in nature,
can address the real economic problems
associated with bank loans going bad is
another question. As this study shows, the
real and asymmetric information problems
associated with bad debt formation requires
close attention.
The converged mean of this ratio is
2.54 per cent, which, although not high
in percentage terms, can primarily translate
into two implications. First, as the total
advance is Rs 6061.51 billion in 2000,
the predicted NPAs would be around
Rs 153.96 billion, which comes to around
Rs 150 per capita. This figure is significant
if confidence in the banking system is
shaken somehow. Second, because according
to the accounting system followed in
commercial banking this 2.54 per cent
is a charge on profits, therefore assuming
rational decision making in the banking
sector, interest rates charged can be expected
to be inflated by at least this figure of
2.54 per cent, which has its own spiraling
effects on growth.
 Dynamics of emerging India’s banking sector assets
Thus, while financial policy attention of
the government seems to be overtly fixed on
the stock market with the emerging markets
regime, cumulative effects of history on the
operation of the commercial banking system
require attention. This attention has to draw
upon the interaction of the small and
medium scale business enterprises which
have no access to the stock market with the
commercial banks as well as the interaction
of the commercial banking sector with the
small and medium sector enterprises which
is the main customer base for commercial
banking. This article finds that this dynamic
relationship is captured stably by regressing
NPAs on themselves one period lagged,
compounded as a ratio with total loans and
advances. A set of dynamic graphs help in
visually understanding the dynamics of
entrepreneurship with banking companies
and their dynamic impact on interest rates.
Banking crises in emerging economies
merit particular attention for two reasons:
(a) the serious consequences for local
economies, and, (b) the fallout in other
countries as financial markets become more
integrated (Goldstein and Turner, 1996).
This article has identified a measure for
estimating dynamically the local impact as
mentioned in (a). Owing to its information
content, simplicity, dynamic ability and
convergence with the large Indian data set,
post-privatization, the p-ratio is a robust
approach to measuring local impact.
It would, also, perhaps not be too casual
a generalization to suggest that the
integration of control over NPAs of banks
and the size of the corresponding loans and
advances (Figure 3) ought to bear a direct
relationship – which means that larger loans
ought to be monitored ‘more’ with respect
of accumulation of defaults than smaller
loans, and this will be able to better integrate
the local emerging economy with local
emerging banks, to give rise to better norms
for the Banking Sector as is the essential
purpose of the Bank for International
Settlements (Goldstein and Turner, 1996).
& 2010 Macmillan Publishers Ltd. 1470-8272 Journal of Asset Management Vol. 11, 1, 62–70
This issue requires further research in the
future.
The current banking crisis in a number of
countries have parallels in the path, which
may be generated by the banking sector
outlined in the article. For example, the
US bailout of defaulting banks’ assets,
as laid out in the Paulson Plan (BBC News
website, November 12, 2008), was an
acknowledgement of the fact that current
bad assets were an outcome of past decisions
and not a random event, and hence required
calculated state intervention. This path-
dependant dynamic is, it is conjectured,
explainable by the dynamic approach of the
model in this article in terms of banking
sector asset accumulation (and bad debts)
over time. To what value the ratio_p would
have converged in the long run in the US
case is beyond the scope of the simple model
in this article. However, it may be able to
generate an alternative framework in terms
of partial nationalization of the infrastructural
sector of banking, if it is shown to be
dynamically stable over time and thereby
create good companies for this infrastructural
sector.
ACKNOWLEDGEMENTS
The authors thank the Planning Commission
of India for financial support. This article has
benefited from comments by Kenneth West,
Frank Hahn, Darrell Duffie, A. Zaman,
M.Gittleman, A. Vinay Kumar, and a referee
and participants at an International
Conference on Entrepreneurial & Small
Business Finance 2006 at IIM Lucknow. The
usual disclaimer applies.
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