The Employees' Provident Fund Organisation (EPFO), which manages over Rs 6,00,000 crore of retirement savings entrusted to it mandatorily by 8.15 crore employees, can no longer invest in the bonds and deposit instruments of these banks as their bad loan levels have breached its internal threshold to define 'safe' investments.

As many as 24 of the 29 public sector banks have net non-performing assets of over 2% of their net advances, disqualifying them from lucrative and predictable inflows from the PF department. These include large lenders like Punjab National BankBSE -0.89 % and the Union Bank of IndiaBSE -0.52 %.

"As per the investment guidelines for provident fund savings, the EPFO can now only invest in term deposits of five public sector banks — Bank of BarodaBSE -0.01 %, Canara BankBSE -0.98 %, Syndicate BankBSE -0.13 %, Vijaya BankBSE 2.26 % and Bank of India," said a senior government official. "These five banks are not the biggest, but their bad loans are still below the threshold limits set by the board," he said.

With the economy shrinking for two years running, coinciding with a sharp contraction in manufacturing and mining output, the spectre of bad loans has got worse across the banking sector in 2013-14, with 36 banks reporting gross NPAs of Rs 2,34,014 crore, 36% higher than a year ago.

The surge in bad bank loans has become a headache for the EPFO which, till last year, had parked over Rs 1.5 lakh crore in public sector financial institutions and bonds, most of which was invested in term deposits of large banks. This investment category accounted for 32% of the retirement fund's total corpus, far higher than its allocation for central government bonds (25%) and state government securities (15%), as of March 2013.

The pressure on EPFO to find alternative avenues for investments could get worse as the government is likely to raise the salary ceiling for mandatory contributions to the EPF scheme from Rs 6,500 per month to Rs 15,000 per month. 24% of an employee's salary up to this ceiling, is statutorily contributed to the EPFO.

Though equity investments by provident funds were allowed by the finance ministry in 2005, the EPFO has not exercised the option and prefers to invest in central and state government bonds (up to 55%) and debt securities, term deposits in scheduled commercial banks and rupee bonds with a tenure of at least three years issued by the World Bank, International Finance Corporation or the ADB. The EPFO is also allowed to park 5% of its fresh inflows in money market instruments.

Term deposits in banks are only permissible if they have been profitable for three years running, maintain capital-to-risk weighted assets ratio of 9% and have net NPAs of not more than 2% of their net advances.

Rana Kapoor, CEO and managing director, Yes BankBSE 0.56 %, said the EPFO must consider expanding its investment horizon and look at private sector banks, who have not only managed risks far more efficiently than their public sector peers amidst a sliding economy, but have also provided attractive returns to depositors.