With net non-performing assets of public sector banks - which account for three-fourths of the entire industry's banking assets - now down to around 1.6 per cent and gross NPAs at 3.5 per cent, India's banking system is vastly different from what it was five years ago.

Then, net NPAs for public sector banks were at 6.74 per cent and gross NPAs at 12.39 per cent. While a large part of this change has been driven by fortuitous circumstances - falling interest rates over the past four years resulted in huge treasury profits which banks used to reduce NPAs - and economic growth, the trend is unlikely to continue without major effort on part of the bank managements.

(These figures relate to NPAs as percentage of advances. If one looks at NPAs as percentage of total assets, as some of the developed economies do, net NPAs in the Indian banking system will be less than half a percentage of total assets and gross NPAs at somewhere around 1.5 per cent, since banks' investments in government securities are virtually risk-free.)

In June this year, as many as 13 PSU banks brought down their net NPA levels to below 1 per cent. Andhra Bank [Get Quote] leads the pack with 0.07 per cent net NPAs, followed by Punjab National Bank [Get Quote] with 0.35 per cent, Indian Overseas Bank [Get Quote] with 0.48 per cent and Oriental Bank of Commerce [Get Quote] with 0.50 per cent.

Even the Chennai-based Indian Bank [Get Quote], which had the dubious distinction of wiping out its entire networth 10 years ago by posting the highest ever net loss by any commercial bank in India, has net NPAs of 0.57 per cent. Its gross NPAs in June were 2.58 per cent. In 2001, its net NPAs were 12.07 per cent and gross NPAs were 21.76 per cent.

There are three broad reasons behind the sharp fall in banks' NPAs and dramatic improvement in the quality of assets.

First, over the past few years the industry made huge profits, riding high on treasury income. With the falling interest rates, bond prices rose and banks made money trading bonds. A substantial portion of the profit was used to write-off NPAs as well as to make provisions for bad loans to clean up the balance sheets.

With every rupee of provision, net NPAs go down, while gross NPAs go down following write-offs of bad assets, recovery of loans, or after the asset quality improves, as often happens when economic growth picks up.

Over the last four years, 27 PSU banks have made close to Rs 29,000 crore (Rs 290 billion) worth of provisions for NPAs on around Rs 1,30,000 crore (Rs 1300 billion) operating profit. In 2003, 31.49 per cent of operating profit was used to make provision for bad assets.

In 2004, the quantum of provision went up to 36.85 per cent. Subsequently, with the gradual slowdown in treasury income and drop in percentage of net NPAs, the industry started making less provisions for NPAs. In 2005, it was 15.65 per cent of operating profit and in 2006, it was 10.09 per cent.

While massive provisioning helped banks clean their books, the instances of fresh slippages or new NPAs have been rare as corporations have been in a better state of health, thanks to the economic buoyancy. They are generating enough cash to clear bank dues without delay.

There is yet another technical factor that has contributed to the lowering of NPAs - the overall growth in the credit portfolio of banks. Since 2005, the incremental credit deposit ratio of the banking system is over 100 per cent. The growth in credit offtake continues to be over 30 per cent, for two successive years. With the phenomenal growth in the overall credit pie, net NPAs have declined as a proportion of total advances.

However, it is still not time to uncork the bubbly yet. The three-legged animal may soon be seen sniffing around and attacking some of the banks' books. In their over-aggressiveness in hunting assets, banks have been sowing seeds for new NPAs.

The average NPA level in home loans is now around 4 per cent and the instances of defaults in credit card outstandings have been rising.

Once, there is a slowdown in corporate earning growth, companies may not be in a position to clear banks' dues regularly. In which case, new NPAs will get generated.

Second, the momentum in credit growth cannot be sustained. In fact, the RBI has made it clear that the pace of credit growth must slow down. So, banks will not be able to bring down the percentage of NPAs by growing their advances aggressively.

Finally, banks will not have enough money to make provisions for NPAs. With the rising interest rates, their treasury income has taken a severe beating.

Most banks have, in fact, been making provisions to mark-to-market their government securities portfolio as bond prices are going below the level at which banks bought those securities.

Banks have been trying hard to maintain their profitability by aggressively making recovery of past bad assets that have already been written off. Once the recovery process is complete and low levels of treasury income - which will be the case in a rising interest rate regime - banks will not have the cushion to make provisions for their bad assets.