Bad Loans: After `Surgery’, Unconditional Capital Will Be A Band-Aid Approach – Finance Guru Tamal Bandyopadhyay Speaks

All hell broke loose two decades ago when Chennai-based Indian Bank posted a Rs.1,336 crore loss for the fiscal year 1996, wiping out its entire net worth.

On Saturday, another government-owned lender, Mumbai-based Bank of Baroda, reported a loss of Rs.3,342 crore in the quarter ended December, the first in its 108-year existence, and the highest-ever in the Indian banking history. In fact, the loss would have been even higher but for a Rs.1,118 crore tax write-back that the bank enjoyed.

However, not too many banking analysts have been shocked. There are reasons behind this. First, the loss was on the expected line. Second, even though the quantum of loss is very high, it is less than 8% of its equity and reserves and hence, Bank of Baroda remains adequately capitalized and there is no risk to its survival. And finally, the bank had the choice to set aside money for its bad loans in two stages for the December and March quarters, but it has done it in one shot even as most others have decided to do this in two stages.

Will the worst be behind India’s state-owned banks by the March quarter when all banks provide for their bad assets?

Both Reserve Bank of India (RBI) governor Raghuram Rajan and finance minister Arun Jaitley stepped in last week to allay the fears of investors even as quite a few public sector banks have been reduced to penny stocks. (Going by the conventional definition of a penny stock, which is traded for less than a dollar, 14 public sector banks are penny stocks now; the US Securities and Exchange Commission has, however, modified the definition to include all shares trading below $5.) Rajan reiterated that this “surgery” was essential to clean up the banking system once and for all and Jaitley reassured that the government would infuse capital in the banks. Both said apprehensions about the health of India’s state-owned banks are exaggerated and there’s no reason to panic.

First, let’s take a look at the performance of these banks in the December quarter. Collectively, the public sector banks have posted a loss of Rs.10,912 crore in the December quarter. Twelve in the pack of 24 public sector banks have recorded net losses, led by Bank of Baroda (Rs.3,342 crore), IDBI Bank (Rs.2,184 crore), Bank of India (Rs.1,506 crore), Uco Bank (Rs.1,497 crore) and Indian Overseas Bank (Rs.1,425 crore). Punjab National Bank could have been in the red had it not recognized deferred tax assets worth Rs.1,132 crore. Its net profit was Rs.51.01 crore.

State Bank of India tops the list of profit-making government-owned banks—Rs.1,115 crore, roughly half of the profit of Axis Bank Ltd and one-third of HDFC Bank Ltd.

Collectively, 39 listed banks have posted a profit of Rs.307 crore in the December quarter against Rs.16,807 crore in the year earlier and Rs.17,411 crore in the three months ended 30 September 2015.

What has killed their profits? Higher provisions or the money that they had to set aside to take care of their ballooning bad assets. Public sector banks’ provisions more than doubled to Rs.43,477 crore in the December quarter from Rs.20,815 crore in the year-ago period. For the entire banking system, provisions rose from Rs.23,646 crore toRs.49,017 crore.

Rs1.3 trillion rise in NPAs

State-run banks needed to provide for so much as their gross non-performing assets (NPAs) rose close to Rs.1.3 trillion in just one quarter, between September and December—from Rs.2.62 trillion to Rs.3.93 trillion. For all publicly traded banks, the rise has been close to a trillion in a quarter—from Rs.3.4 trillion to Rs.4.38 trillion. If we compare this with the year-ago period, then the gross NPAs have risen by almost 50% for the industry, from Rs.2.92 trillion in December 2014.

After provisions, net NPAs of the Indian banking industry in the December quarter crossed Rs.2.5 trillion, about 48% higher over December 2014. The state-run banks account for more than 90% of this—Rs.2.31 trillion.

Finally, take a look at the NPAs as a percentage of loans. Fifteen Indian banks now have at least 7% and up to 12.64% gross NPAs and only one of them is from the private sector (Dhanlaxmi Bank Ltd, 9.69%). For many of them, the growth has been more than 5 percentage points in the December quarter. Even after massive provisioning, nine public sector banks have more than 5% and up to 8.32% net NPAs. State Bank of Bikaner and Jaipur has the lowest level of net NPAs, 2.2%.

Villain of the piece?

Why has there been a sudden surge in NPAs in the December quarter?

In private, bankers blame the RBI’s asset quality review as the villain of the piece. In the five months between August and December, RBI executives of the rank of a general manager and above trooped down to all banks, one in each bank as a ‘senior supervisory manager’ and inspected their books.

Following the review, banks were asked to make provisions for three types of assets—new NPAs that were earlier not recognized by them; loans given to various projects where dates of commencement of commercial operations have passed but the projects have not yet taken off; and loans that have been restructured.

For the restructured loans, banks have been asked to make 15% provision in six quarters, 2.5% each.

The bank managements were given the freedom to make provisions in two phases for the December and March quarters, at least 50% each. Bank of Baroda and a few others have done this at one go, while most will complete it in March.

Bankers are not particularly happy with certain aspects of the asset quality review. For instance, some of the large accounts have not been uniformly recognized as NPAs in the books of all banks (probably the large borrowers are selective in paying back loans—they pay to a few banks and not all). The review could also have taken a little lenient view on those roads and toll bridge projects where commercial production has not started because of lack of clearances by regulatory authorities.

However, the results of the review have made it clear that the banks were either in denial or hiding their bad assets.

Will the pain be over in the March quarter when full provisioning is done? I don’t think so.

T ypically, Indian banks do sketchy audits of branches in the first three quarters of any financial year, but in the last quarter, many more branches are audited. When this happens in the March quarter, more bad assets could be brought on the table. There could also be further slippages—good assets turning bad. Also, the banking regulator may decide to do another round of asset quality review next year before the deadline of cleaning up books—March 2017—expires.

In a recent presentation at a banking seminar hosted by an industry body, RBI deputy governor S.S. Mundra has pointed out that in the September quarter, the combination of recognized NPAs, restructured assets as well as written-off assets was to the tune of 17% for public sector banks and 14.1% for the industry. With the sudden surge of bad assets in December, the overall stressed assets have probably crossed 20% for state-run banks and will rise even further in March.

Loan write-offs

The Indian Express last week reported that public banks wrote off Rs.1.14 trillion of bad debts in the past three years between 2013 and 2015. Since 2004, the amount of loans written off has been Rs.2.11 trillion. My understanding is, in the past 15 years, the Indian banking system has written off at least Rs.3 trillion.

Reacting to the report, the finance ministry has said that write-offs are basically technical and are done within the framework of the Income Tax Act and RBI guidelines. They are part of the balance sheet cleaning exercise and the loans continue to remain outstanding in the branch books.

RBI too has said in “technically written off” accounts, loans are written off from the books at the head office without foregoing the right to recovery and generally, they are provided for and once recovered, the provisions made for those loans flow back into the profit and loss account of banks.

What started as a practice for tax savings has probably become a tool to suppress the gross NPAs figures for the banking system as such written-off accounts no longer remain on the balance sheets of banks. If write-offs are done indiscriminately, it creates moral hazards, weakens the credit risk management system, leads to a non-transparent accounting system and makes the financial system inefficient.

As a concept, technical write-off is unique to India and the banks need to be transparent in justifying such write-offs. Such written-off advances are backed by tangible securities with substantial recoverable value. Since they get the tax benefit on the written-off loans and also depress their gross NPAs, the banks must explain what happens to such accounts and their monitoring and reporting mechanisms. I am told close to Rs.2 trillion of the Rs.3 trillion written-off loans have remained outstanding.

After surgery, what?

Rajan has been saying that a band-aid approach will not work and the banks need deep surgery. That’s fine, but how does he ensure that after surgery, some of the banks won’t suffer from multiple-organ failures or sink into irreversible coma? What kind of medicine should be administered to ensure a quick recovery?

The government pumped in Rs.67,734 crore capital since 2010 to keep the public sector banks running. It has agreed to infuse an additional Rs.70,000 crore and will probably put in even more money, if required. Rating agency Crisil Ltd believes intensifying asset quality problems at public banks have the potential to impair their credit risk profiles and necessitate significantly higher capitalization. Over the past 18 months, Crisil has either downgraded or revised its outlook to ‘Negative’ on nine out of the 25 public banks that it rates because of worsening asset quality.

However, can capital alone solve the problem? The answer is no. In fact, that will be a band-aid approach. What’s the guarantee that after starting with a clean slate and adequate capital, the public banks will not face the same situation a few years down the line?

Officially, public sector bankers take enormous pride in being the torchbearers of social banking because the government wants them to give money to certain sectors and they oblige their majority owner even though they don’t understand the risks of lending to such sectors, but that’s only one part of the story of bad assets. It’s a heady cocktail of obsession for balance-sheet growth, adventurism, lack of understanding of risks in project financing and, in some cases, even lack of integrity. Unconditional fresh capital will encourage them to commit the same mistakes again.

‘Brotherhood banking’

Often, when banks don’t understand the risks involved in financing a project, “brotherhood banking” takes place. What’s that? Well, there have been many instances of executives of one particular bank becoming chiefs of many public banks around the same time. There is nothing wrong in it as they go through the normal selection process to move to the corner room of different banks. But once they settle down, one of them who is relatively more qualified than others in appreciating project financing, takes a call on large loan proposals and influences his former colleagues who now head other banks to take the plunge.

The brokers have also been playing a critical role as an intermediary between loan seekers and banks. Dozens of broking outfits have come up in the past few years who arrange loans at a commission and thrive on bankers’ ignorance of project financing. Such outfits have contributed significantly to the deterioration of assets in the banking system.

Finally, for many public banks, the boards are the biggest risk as not all their directors understand the business of banking. They cannot guide the management, do not hold the CEO accountable, and some of them even broker loan deals.

No public sector bank chief has ever been sacked for inefficiency. They do get removed for corruption, even though such instances are rare. In the worst-case scenario, the inefficient bankers don’t get a second term if their first term as boss ends before the retirement age (60).

Before releasing capital, the government must put in place a transparent reward and punishment policy for bank CEOs and overhaul bank boards even if they cannot change the ownership structure overnight, as that’s a politically sensitive issue. The bank management must be made accountable as it is dealing with depositors’ money to do business and taxpayers’ money to survive. 

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* This article was first featured in Mint

About the Author

Tamal Bandyopadhyay is one of the most respected business journalists in India. Currently, he is a Consulting Editor of Mint, writes a weekly column on Mint – Banker’s Trust, which is widely read for its deep insights into the world of finance.  He is also an Adviser on Strategy for Bandhan Bank.

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