International Research Journal of Finance and Economics ISSN 1450-2887 Issue 65 (2011) EuroJournals Publishing, Inc. 2011 http://www.eurojournals.com/finance.

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An Empirical Analysis and Comparative Study of Credit Risk Ratios between Public and Private Sector Commercial Banks in India
Somanadevi Thiagarajan Ph.D. Scholar, Management Sciences, Anna University of Technology, Coimbatore, India Lecturer (on leave) Faculty of Management, University of Belize, Belize E-mail: somanadevi@yahoo.com A. Ramachandran Director, SNR Institute of Management Sciences, SNR sons college, Coimbatore, India E-mail: ram1200@rediffmail.com Abstract Indian banking sector has expanded in an exponential manner in the past decade offering a wide range of services to rural, urban and metropolitan areas of the country. The banking sector reform initiated by the Reserve Bank of India has created a competitive environment for both public and private sector banks and are therefore vigorously expanding their customer base to offer various services. In light of the recent global financial crisis, risk measurement and management in the Indian banking sector is gaining importance. Credit risk is the core of all banking activities to both private and public sector banks. In light of this, a study was carried out to measure the credit risk component of the Indian Scheduled Commercial Banking sector by using data from the past ten years (2001 2010). Our study illustrates how certain key credit risk ratios can be used to measure the credit risk in the banking sector. The results indicate that there is a consistent increase in the total loans to total assets ratio and total loans to total deposits ratio for both public and private sector during the period of study. Although there was a gradual decrease in the ratio of nonperforming loans to total loans for both public and private sector banks from 2001 to 2008, there has been a gradual increase from 2009 to 2010 and this increase is significantly higher for private sector banks over their public sector counterparts. Also there is a drastic and significant increase in the total loans to total equity ratio in the public sector banks during the last four years. The correlation analysis of the credit risk ratios with macroeconomic indicators also revealed some unique and interesting positive and negative correlations that would shed more light on the nature of the risks associated with the commercial banking sector in India. Since the study used all the empirical data that are readily available for each bank with in their respective sector, corrective measures can be made as part of the internal risk assessment system as recommended by the Reserve Bank of India.

Keywords: Credit Risk Ratios, Economic Indicators, Private Sector Banks, Public Sector Banks

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1. Introduction
Financial security is an important and crucial component to the banking sector due to the economic repercussions that failure of a large bank could have on the financial system as a whole. Banking in modern economies is all about risk management. Unsound risk management practices governing bank lending played a central role in recent episodes of financial turmoil (Rahman et al., 2004; Atikogullari, 2009). Banks generally face various risks such as credit risk, market risk, operational risk, liquidity risk etc. Of all the type of risks, credit risk is the most important one hence it underpins the very existence of the banking system (Das and Ghosh, 2007). Since credit risk is all about loans and their defaults, and loan transactions account for more than 50% of all banking activities, credit risk must be carefully monitored by the banking sector (Karunakar et al. 2008). The implementation of Basel II Accord is likely to lead to a sharper focus on the risk measurement and risk management at the institutional level. The Basel Committee has, through its various publications, provided useful guidelines on managing the various facets of risk (BIS 2004, 2005). The Basel Committee on banking Supervision defines credit risk as potential of a barrower to meet the obligation in accordance with the agreed term. Banks must have prudent policies that would allow them not only to monitor the entire credit portfolio, but also to scrutinize individual loan transactions. There are 81 Scheduled Commercial Banks (SCBs) in India which include 27 public sector banks, 22 private sector banks and 32 foreign banks. In recent years, the public sector banks have contributed to over 70% per cent of the banking assets. The Indian private sector banks contributed about 20 per cent, while foreign banks accounted for less than 10% cent of the total banking assets (Reserve Bank of India, 2010). The sound risk management practices by the Indian Scheduled Commercial Banks (SCBs) would be an important pillar for staying ahead of the competition in the global financial market. The Indian banking sector has undergone major changes since the deregulation which started in the early 1990s. Although the regulatory agency the Reserve Bank of India (RBI) sets policies and guidelines for the banking sector, individual banks can develop and implement many of their own policies and regulations within the norms set by RBI. Basel II also suggests that banks can develop their own internal risk management procedures but advices that such approach be disclosed to the regulatory body. In light of that the current study is undertaken to analyse the various credit risk related ratios for both public and private sector banks and correlate those ratios with key macroeconomic indicators. Also this study attempts to find out if any particular ratio or correlation is unique to a particular sector. The article is composed of three sections. The first section gives historical perspective of the credit risk and the second section deals with the credit risk ratios from the two banking sectors namely public and private sector. The third section deals with the correlation of the credit risk ratios with key macroeconomic indicators.

2. Previous Research
Studies in the past have compared various parameters related bank performance including credit risk measurement and management between Private and Public Sector Banks. A review of the literature on this topic shows that there is no consensus on the ownership of banks and their performance. Some studies have revealed that bank performance improved when state owned banks were either fully privatized or partially privatized. There are other reports that suggest that public sector banks performed better than private sector banks. A study carried out by Sinkey and Greenwalt (1991) on the loan-loss experience and risk taking behavior of commercial banks in the United States of America, showed that credit risk mainly arise from poor lending policies and bad macroeconomic conditions. Caprio and Klingebiel (2000) reported that many state-owned banks showed poor financial performance due poor management and politically motivated loan disbursements. Bratanovic and Greuning (2000) recommended that credit risk ratios can be used as a measure of the credit risk associated with the banking sector and highlighted the usefulness of such ratios for banks to internally lower the ratio and avert any catastrophic failures.

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A study by Salas and Saurina (2002) on Spanish commercial and saving banks, revealed that growth in GDP, rapid credit expansion, bank size and capital ratio influenced the Non Performing Loans. Hanson and Kathuria (2002) found that the banking system in India was making slow progress in the management of non-performing assets (NPAs) and suggested that improvement must be made to reduce the NPAs. Rajan and Dhal (2003) reported that macroeconomic conditions such as higher GDP growth and bank specific factors such as maturity, terms of credit, banks size impacted significantly on the Non Performing Assets of commercial banks in India. Sathe (2003), while studying the performance of Indian commercial banking sector found that the public sector banks performed better than their private sector counterparts with regards to their overall efficiency. He also raised concern over the higher level of Non-performing Assets (NPA) in the banking system and suggested that policies be implemented to reduce the bad loans. Hu et al (2004) found that the public sector banks in Taiwan performed better with regards to performance and risk management practices than the private sector banks. Safakli (2007) did an extensive study of credit risk associated with the banking sector and Northern Cypress and found that the credit risk ratios were indicative of the credit risks associated with the banking sector and correlated the risk ratios with key macroeconomic indicators. In a recent study, Aman and Zaman (2010) found that the private sector banks in Pakistan have shown good performance of credit management and increased market share over the state owned banks and hence contributed effectively to the economy.

3. The Source of Data and Methodology

The data for both bank specific factors such as net Non Performing Assets (NPA), total loans, total deposits, total equity, total assets, operating expenses, etc., have been obtained from audited statements of the individual banks and also from the Reserve bank of India website at www.rbi.org.in. The basic macroeconomic indicators such as Gross Domestic Products (GDP), inflation rate, export/import (%) ratio, real effective lending rate, real effective exchange rate etc have been obtained from the Reserve bank of India website at www.rbi.org.in. Some of the data are collected from reputed data sources such as Centre for Monitoring Indian Economy (CMIE), Capital Line Plus & Economic Intelligence Service (EIS). A total of 38 Scheduled Commercial Banks that were listed in the Bombay Stock Exchange (BSE) were chosen for this study based on the availability of the data for the entire 10 year period from 2001 to 2010. The data for each of the 22 public sector banks and 16 private sector banks were collected and was grouped as listed in Table 1. The period chosen is significant because the Indian banking sector has undergone significant expansion due to deregulation and opening of the market to foreign banks which created a competitive environment. The later part of the past decade has also seen turmoil in the global financial markets due to sub-prime mortgage crisis in the major economies of the world. The credit risk ratios anlysed in this study are: The ratio of total loans (TL) to total assets (TA) The ratio of non-performing assets (NPA) to total loans (TL) The ratio of total loans (TL) to total deposits (TD) The ratio of total equity (TE) to Total assets (TA) The ratio of total loans (TL) to total equity (TE) The ratio of total assets (TA) to total Gross Domestic Product (GDP) The ratio of provisions for loan loss (PFLL) to non-performing assets (NPA) The ratio of non-performing assets (NPA) to NPA and total equity (NPA + TE) These ratios for each bank was calculated for each year and used as sample and the statistical analysis was carried out by using SPSS and was tabulated by group. The means for each ratio for each sector was separately correlated with key economic indicators such as Inflation rate, GDP, export/import ratio (%), real effective lending interest rate (RELR) and real effective exchange rate (REER).

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Table 1: List of public sector and private sector banks used in this study
Private Sector Banks Axis Bank Bank of Rajasthan City Union Bank Development Credit Bank Dhanlaxmi Bank Federal bank HDFC Bank ICICI Bank Indusind Bank ING Vysya Bank Jammu & Kashmir Bank Karnataka Bank Karur Vysya Bank Kotak Mahindra Bank Lakshmi Vilas Bank South Indian Bank

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Public Sector Banks Allahabad bank Andhra Bank Bank of Baroda Bank of India Bank of Maharashtra Canara Bank Central Bank of India Corporation bank Dena Bank Indian Bank Indian Overseas Bank Oriental Bank of Commerce Punjab National Bank State Bank of Bikaner and Jaipur State Bank of India State Bank of Mysore State Bank of Travancore Syndicate Bank UCO Bank Union Bank United Bank of India Vijaya Bank

4. Results and Discussion

4.1. The Results for the Credit Risk Ratios The mean for each credit ratio from both public and private sector banks were analysed for significance by using an ANOVA test. The results were graphically represented for a clear understanding of the trend over the ten year period under study and also to visually see the differences between the two sectors. 4.1.1. The Ratio of Total Loans to Total Assets (TL/TA) Figure 1 shows a fairly consistent increase in the ratio of total loans to total assets (TL/TA) for both public and private sector banks over the ten years. The ratios of TL/TA for private sector banks were higher for period 2001 to 2005 but from 2007 to 2010, the ratios of TL/TA for public sector banks were significantly higher than the private sector banks. Since higher ratios signify an increase in loan portfolio over the asset the credit risk for the public sector is gradually increasing and the total loans is reaching over 60% of the total assets. This trend should be monitored in conjunction with the nonperforming assets. Hence loans are the major part of the banking activities and public sector banks reach out to various demographics of the country, it is expected that their loan portfolio is higher than that of the private sector banks.
Figure 1: The Ratio of Total Loans (TL) to Total Assets (TA)
.7

.6

Mean TL/TA

.5

.4

Bank Type Public

.3 2001 02 03 04 05 06 07 08 09 2010

Private

Year

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4.1.2. The Ratio of Non- Performing Assets to the Total Loans (NPA/TL) Figure 2 shows that both public and private sector banks consistently lowered the ratio of total nonperforming assets to the total loans from 2001 to 2008. However there is a gradual increase in the ratio for 2009 and 2010. Although the ratio is showing an overall favorable scenario, given the volume of loans and the increase in the ratio during the last two years, both sectors need to watch the NPAs carefully as this can pose a problem if the trend continues and macroeconomic conditions change. The ratio for the private sector banks was significantly higher than the public sector banks from 2004 to 2010. Nonperforming loans to total loans is an important indicator that each individual bank can monitor carefully and make corrective measures as necessary. A study by RBI (Reserve Bank of India, 2010) suggests that there is a lag period of at least two years between the credit growth and growth in NPAs. This underlines the pro-cyclical nature of banking system where asset quality is compromised during the period of high credit growth and this can lead to the increase in the Non Performing Assets in the later years.
Figure 2: The Ratio of Non-Performing Assets (NPA) to Total Loans (TL)
.08

.06

Mean NPA/TL

.04

.02

Bank Type

Public
0.00 2001 02 03 04 05 06 07 08 09 2010

Private

Year

4.1.3 The Ratio of Total Loans to Total Deposits (TL/TD) The ratio of total loans to total deposits seems to be similar to both sectors from 2006 to 2010. However from 2001 to 2005, the ratio (TL/TD) for the private sector banks was significantly higher than the public sector banks (Figure 3). It seems corrective measures were taken by the private sector banks to bring it in line with the public sector banks and this may be due to advisories issued by RBI. However the ratio shows a constant increase since 2001 for both sectors and the total loans now stand over 70% of total deposits. Also there is no statistically significant difference between two sectors from 2006 to 2010.
Figure 3: The Ratio of Total Loans (TL) to Total Deposits (TA)
.8

.7

Mean TL/TD

.6

.5

Bank Type

Public
.4 2001 02 03 04 05 06 07 08 09 2010

Private

Year

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4.1.4. The Ratio of Total Equity to Total Assets (TE/TA) Figure 4 shows that ratio for total equity to total assets (TE/TA) was significantly higher for the public sector banks for the period of 2001to 2005. However the trend changed and the ratio for private sector banks have increased from 2006-2010. It should be noted that the ratio for the private sector banks for the period from 2007 to 2010 was significantly higher than the public sector banks and this may be due to the fact private sector banks were succesful in raising their equity through public share offering.
Figure 4: The Ratio of Total Equity (TE) to Total Assets (TA)
.03

.02 Mean TE/TA .01

Bank Type Public

0.00
2001 02 03 04 05 06 07 08 09 2010

Private

Year

4.1.5. The ratio of Total Loans to Total Equity (TL/TE) Figure 5 shows that the ratio of total loans to total equity has intialy higher for the private sector for the period 2001 2004, however the trend changed drastically as years progressed. During the period from 2006 to 2010, the ratio TL/TE for public sector banks has shown a significant increase and it should be monitored carefully due to the volume of the loans in this sector. The increase in total loans could be due to anticylcial measures taken by RBI to offset the effects of the financial recession that occurred elsewhere in the world.
Figure 5: The Ratio of Total Loans (TL) to Total Equity (TE)
400

300

Mean TL/TE

200

100

Bank Type
Public
0 2001 02 03 04 05 06 07 08 09 2010

Private

Year

4.1.6. The Ratio of Total Assets to Gross Doemestic Products (TA/GDP) Figure 6 clearly shows that both sectors have increased their total assets constantly over the past ten years, the public sector is doing exceptionally well inthis regards. It should be noted that the public sector banks contribute to over 70% of the fiancial activites of the country and also contribute

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significantly to the national GDP. This is due to the fact that the number of branches and the volume of transactions by the public sector banks are much higher than the private sector banks.
Figure 6: The Ratio of Total Assets (TA) to Gross Domestic Product (GDP)
.06

.05

Mean TA/GDP

.04

.03

.02

Bank Type
.01

Public Private
2001 02 03 04 05 06 07 08 09 2010

0.00

Year

4.1.7. The Ratio of Provisions For Loan Loss to Non-Performing Assets (PFLL/NPA) It is clear from the figure 7 that both sectors have constantly increased the provisions against nonpeforming assets such as bad loans and defaults. Although private sector banks made higher provisons for most of the years, the public sector banks also increased their provisons for loan loss towards the later part of the period. This ratio is significantly high for the year 2010 for the provate sector banks. Since PFLL is positively correlated with credit risk associated with the banking sector (Ahmad and Ariff, 2007), this ratio suggests that private sector banks are exposed to credit risk more than the public sector banks.
Figure 7: The Ratio of Provisions for Loan Loss (PFLL) to Non-Performing Assets (NPA)
1.8 1.6 1.4

Mean PFLL/NPA

1.2 1.0 .8 .6

Bank Type
.4 .2 0.0 2001 02 03 04 05 06 07 08 09 2010

Public Private

Year

4.1.8. The Ratio of Non-Performing Assets to Non-Performing Assets and Total Equity (NPA/NPA + TE) The ratio of nonperforming assets to nonperforming assets and total equity is significantly higher for the public sector banks from 2007 2010. This combined with the low provisions made by the public sector banks for NPA as shown in figure 7, must be noted and monitored over the coming years. Since the global economy is still on shaky grounds due to various socio-political uncertainties in the Middle East, the public sector banks must pay attention to the gradual increase in the NPA in the recent years.

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Figure 8: The Ratio of NPA to NPA and Total Equity NPA/NPA + TE
.8

89

.7

Mean NPA/NPA+TE

.6

.5

Bank Type
.4

Public
.3 2001 02 03 04 05 06 07 08 09 2010

Private

Year

4.2. Results for the Correlation Analysis of Credit Risk Ratios and Economic indicators This part of the study was carried out to see if there are any statistically significant correlations between the credit risk ratios studied and the key macroeconomic indicators. The results for the Pearson correlation by using a 2 tailed test are shown in Table 2 and Table 3 for the public and private sector banks respectively. For the public sector banks (Table 2) there is a statistically significant high negative correlation that exists between the Export/import (%) ratio and the ratio of total loans to total assets (TL/TA), total loans to total deposits (TL/TD), total loans to total equity (TL/TE) total assets to GDP (TA/GDP) and provisions for loan loss and nonperforming assets (PFLL/NPA). This suggests that when exports are favorable, loan repayment seems to be doing alright. A negative correlation was also found between real GDP and the ratio of nonperforming assets to total loans (NPA/TL), total loans to total deposits (TL/TD), total equity to total assets (TE/TA), nonperforming assets to nonperforming assets and total equity (NPA/NPA+TE). When GDP grows, usually there is a decrease in the nonperforming loans in the banking sector (Das and Ghosh, 2007). A significant positive correlation was observed between inflation and total loans to total assets (TL/TA) ratio, total loans to total equity (TL/TE) ratio, and total assets to GDP (TA/GDP) ratio for the public sector banks.
Table 2: Correlation between Credit Risk Ratios and Key Economic Indicators of Public Sector Banks
Inflation 0.765** 0.010 10 -0.536 0.110 10 -0.760* 0.011 10 -0.713* 0.021 10 0.937** 0.000 10 0.941** 0.000 10 GDP 0.633* 0.049 10 -0.781** 0.008 10 -0.647* 0.043 10 -0.680* 0.030 10 0.414 0.234 10 0.372 0.269 10 Ex/im% -0.989** 0.000 10 0.903** 0.000 10 -0.990** 0.000 10 0.980** 0.000 10 -0.931** 0.000 10 -0.911** 0.000 10 RELR 0.444 0.199 10 -0.082 0.822 10 0.428 0.217 10 -0.269 0.452 10 0.484 0.158 10 0.449 0.193 10 REER -0.324 0.362 10 0.223 0.535 10 -0.315 0.376 10 0.325 0.360 10 -0.567 0.087 10 -0.609* 0.062 10

Credit Risk Ratios TL/TA

NPA/TL

TL/TD

TE/TA

TL/TE

TA/GDP

Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N Pearson Correlation Sig. (2-tailed) N

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Table 2:
PFLL/NPA

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Correlation between Credit Risk Ratios and Key Economic Indicators of Public Sector Banks
0.684* 0.029 10 -0.850** 0.002 10 -0.799** 0.005 10 0.647* 0.043 10 0.388 0.268 10 0.060 0.868 10 -0.227 0.528 10 -0.228 0.527 10

Pearson Correlation 0.618 Sig. (2-tailed) 0.057 N 10 NPA/NPA+TE Pearson Correlation 0.045 Sig. (2-tailed) 0.901 N 10 ** Correlation is significant at the 0.01 level (2-tailed). *Correlation is significant at the 0.05 level (2-tailed).

For private sector banks (Table 3) a statistically significant high negative correlation was observed between the Export/import % ratio and the ratio of total loans to total assets (TL/TA), total loans to total equity (TL/TE), total assets to GDP (TA/GDP), and provisions for loan loss to nonperforming assets (PFLL/NPA). A negative correlation was also found between real GDP and nonperforming assets to nonperforming assets and total equity (NPA/NPA + TE). A significant positive correlation was observed between inflation and total loans to total equity (TL/TE) ratio, and total assets to GDP (TA/GDP) ratio. There was a significant positive correlation that was observed between the real effective exchange rate (REER) and the ratio of nonperforming assets to total loans (NPA/TL) and total equity to total assets (TE/TA) in the private sector banks that was not observed in the public sector banks.
Table 3: Correlation between Credit Risk Ratios and Key Economic Indicators for Private Sector Banks
GDP 0.642* 0.045 10 -0.250 0.486 10 -0.243 0.499 10 -0.100 0.783 10 0.282 0.429 10 0.598 0.068 10 0.456 0.185 10 -0.754* 0.012 10 Ex/Im% -0.955** 0.000 10 0.390 0.265 10 0.035 0.924 10 0.217 0.547 10 -0.746* 0.013 10 -0.976** 0.000 10 -0.636* 0.048 10 0.923** 0.000 10 RELR 0.336 0.343 10 0.309 0.384 10 -0.206 0.567 10 0.346 0.327 10 0.329 0.354 10 0.445 0.197 10 0.424 0.222 10 -0.442 0.200 10 REER 0.270 0.451 10 0.681* 0.030 10 -0.114 0.729 10 0.779** 0.008 10 -0.673* 0.033 10 -0.405 0.246 10 -0.443 0.200 10 0.093 0.798 10

Inflation Pearson Correlation 0.682* Sig. (2-tailed) 0.030 N 10 NPA/TL Pearson Correlation -0.402 Sig. (2-tailed) 0.250 N 10 TL/TD Pearson Correlation -0.101 Sig. (2-tailed) 0.781 N 10 TE/TA Pearson Correlation -0.386 Sig. (2-tailed) 0.271 N 10 TL/TE Pearson Correlation 0.915** Sig. (2-tailed) 0.000 N 10 TA/GDP Pearson Correlation 0.826** Sig. (2-tailed) 0.003 N 10 PFLL/NPA Pearson Correlation 0.765** Sig. (2-tailed) 0.010 N 10 NPA/NPA+TE Pearson Correlation -0.616 Sig. (2-tailed) 0.058 N 10 ** Correlation is significant at the 0.01 level (2-tailed). *Correlation is significant at the 0.05 level (2-tailed).

Credit Risk Ratios TL/TA

Studies during the past decade showed empirical evidence of a negative relationship between the growth in GDP and NPAs (Salas and Suarina, 2002; Rajan & Dhal, 2005). The support for this relationship is that strong positive growth in real GDP usually translates into more income for the borrower and hence improves the debt servicing ability of the borrower. This translates in to lower Non-Performing Assets (NPA). That means when there is a slowdown in the economy the level of

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NPA may increase. Fofack (2005) showed that there is a positive relationship between the inflation rate and non-performing loans in a number of Sub-Saharan African countries. However there was no such positive correlation found in our study between the inflation and the non performing assets.

5. Conclusions and Policy Implications

This study attempted to analyse various risk related ratios that could to be useful as an internal risk monitoring tool for the scheduled commercial banks. Although there are similarity in the trend of certain ratios over the ten year period studied, the sector wise comparison showed there are significant differences between the two sectors with regards to certain key ratios such as total loans to total equity (TL/TE) provisions for loan loss to total NPA (PFLL/NPA) and the NPA to NPA and total equity (NPA/NPA+TE). Since risk is contagious, and the public sector banks handle large volume of loans; the recent trend in the increase of the non performing loans in the commercial banking sector poses a serious concern. This trend needs better monitoring and requires necessary corrective measures. The negative correlation between certain ratios and the export/import % should also highlight that when macro economic conditions change and if exports decrease, the export based companies can default and add to the non performing loans which could trigger a credit risk crisis. To effectively manage the credit risk in the Indian Scheduled Commercial Banking sector (SCBs), the Reserve Bank of India has developed policies and guidelines in accordance with the norms set out by Basel Committee on Banking Supervision otherwise known as the Basel II accord. Since credit risk is associated with traditional lending activities of the bank, banks can monitor various credit risk associated ratios by using their internal data. Hence the Core Banking System (CBS) that is now being fully implemented in the Indian Scheduled Commercial Banks, the data for such ratios can be easily obtained and credit risk can be monitored effectively and internal corrective measurements can be taken on a timely manner to avert any catastrophic effects. Since the Scheduled Commercial Banking sector is the driving engine of the Indian economy and the credit risk associated with this sector is very significant, the RBI is keen on monitoring this sector and develops policies and other corrective measures as necessary.

Acknowledgement
The authors thank Dr. Leopold Perriott, Associate Professor of the University of Belize for his technical assistance during the data analysis.

References
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