Bank NPAs are just the tip of the iceberg

With losses being reported in the current quarter and the next, the rating of many PSU banks will go below the radar and if a downgrade happens, they will find it difficult to raise resources plus the cost of borrowings will go up for them. And after having burnt their fingers in the past, the risk-taking ability of many of the banks will diminish further and the slowdown will continue.

Though the government has so far committed around Rs 25,000 crores to the banks and an assurance to fund further, given its deficit financing compulsions and the need to provide for the Pay Commission/OROP recommendations in the next fiscal, and the poor disinvestment cash flows, the government would find it difficult to pump in the required capital.

Once these banks start showing losses, they will not be able to pay dividends to the government nor pay taxes, which will further aggravate the situation for the government as its return on investment as an investor would be very negligible for the next few years, says M V Subramanian.

Finance Minister Arun Jaitley sought to draw a line over the bad loan problem afflicting State-run banks, saying there had been an over-reaction and that the matter would be under control soon. He also urged investors to appreciate the strengths of the Indian economy and not get swayed by international developments.

Was he right in communicating that all is well with the banks and that in all earnest, the banks would be in a position to recover these bad loans in the near future?

The State Bank of India, the largest lender, announced a 61 per cent drop in profits for the third quarter of 2015-16 and warned of worse to come in the next quarter. A higher provisioning for bad assets and contingencies dragged down Punjab National Bank’s net profit by 93 pc to Rs 51 crores, while Canara Bank’s profit eroded by 87 pc, to Rs 85 crores.

Managing directors of two leading private sector banks (ICICI Bank and Axis) have also confirmed that the pain will continue in the next quarter, through the Reserve Bank of India had given time to all the banks to clean up their books by March 2017.

In order to improve the financial health of PSU banks, the government is considering more steps to empower them to recover bad loans. “The bankruptcy law is under active consideration. The government is also considering some further steps to empower banks to be in a position to recover these monies. I think it’s a problem which will soon come under control,” Jaitley has said.

The quarterly results announced so far give realistic NPA levels in the leading PSU banks and the losses (ie, due to provisions for bad loans) amounting to over Rs 10,866 crores for eight of the banks and their gross NPAs aggregating to Rs 1,64,846 crores.                                                                       

The above table clearly reveals that the banks, under compulsion from RBI, as part of their Asset Quality Review have finally come to terms about recognising the NPAs in their books and have started provisioning for the bad loans. But why did they not do it on their own? What happened to corporate governance standards, more so in private sector banks where the management is supposed to be professionalised? Why are banks putting the blame on RBI’s AQR as the reason for realistic provisioning and agreeing to treat some of the large bad loans as NPAs, when they are treated as NPAs in many other banks?

With the AQR, some of the accommodative structures practised by a few banks to treat the accounts as standard have now been exposed by the regulator.

The above table also indicates that the gross NPA ratio for most banks is above 8 pc and it may well go up to 12 pc in the next two quarters. Leading rating agencies in India have predicted an average of 12 pc of the assets for PSU banks, without taking into account the restructured assets portfolio. The RBI governor has warned that this amounted to ‘scare-mongering’ but obviously, he had to defend his action.

Also, it is clear from the past, that 60 pc of the exits from the restructured assets portfolio (this is apart from the NPA book, and is unique to India in that the assets are kept in this incubator while nursing an asset by sacrificing the principal and/or interest) turn out to become NPAs and only 40 pc of the restructured assets move back to standard assets. This ratio is likely to remain in the coming two to three quarters as the turnaround in the manufacturing/power/commodities/metals/roads/real estate sector is yet to happen and the companies from these sectors have no cash flows to repay debt or to service the interest component.

It is a paradox that while the Indian economy is growing at over 7 pc, the health of the banking system is becoming weaker and weaker. Seventy percent of the assets are managed by PSU banks and if they have to further lend/to be in the business, huge capital needs to be provided in the next one year. Some estimates say that around Rs 2,50,000 crores ($ 40 billion) is realistically required by all the banks to fund the losses and to meet Basel III requirements in the next two years.

Though the government has so far committed around Rs 25,000 crores and an assurance to fund the banks further, given its deficit financing compulsions and the need to provide for the Pay Commission/OROP recommendations in the next fiscal, and the poor disinvestment cash flows, the government would find it difficult to pump in the required capital.

Once these banks start showing losses, they will not be able to pay dividends to the government nor pay taxes, which will further aggravate the situation for the government as its return on investment as an investor would be very negligible for the next few years.

The government had also not spelt out clearly whether it will still want to maintain its majority stake-holding in PSU banks or it is willing to come to down to 51 pc in the short term and eventually hold lesser share. This has lots of political ramifications and at the present time, the government will not venture into privatising PSU banks. This was the recommendation of the Dr PJ Nayak committee but the government was not in support of this move.

During September 2015 the government announced its Indradhanush revamp plan for PSU banks to improve their performance by appointing chairman and bringing in professionals to head the banks, setting up the Banking Board Bureau (though it is only on paper as the BBB is yet to become operational) and giving more autonomy to all the banks without any government interference and governance reforms. But this alone will not wish away the NPA problem and recapitalisation.

With the losses being reported in the current quarter and the next, the ratings of many PSU banks will go below the radar and if a downgrade happens, they will find it difficult to raise resources plus the cost of borrowings will go up for them. And after having burnt their fingers in the past, the risk-taking ability of many of the banks will diminish further and the slowdown will continue.

With the declining interest rate scenario, though the RBI may bring down the monetary rate (which is unlikely for the next six months), these banks cannot risk transmitting the rates to borrowers as that will impinge on the margins of all banks. Their core funding from fixed deposits will continue with higher rates to attract and retain their deposits. As the government needs borrowings from the market at a higher level, the SLR requirements for the banks will continue at the present level.

The corporate loan book is growing in single digits, which will go down further in the quarters to come. Also, with the beating down of the share prices of PSU banks for the past three months, the investors will also think twice over any new issues of capital. This has happened for many leading banks across the globe post the 2008 meltdown and some of the banks’ stock prices have not gone up even after eight years.

What are the real issues from the quantum of Non Performing Assets in the banks, and why is it that all of a sudden, banks’ financial results show a very alarming status of the NPA book?

The underwriting standards of the banks are weak and a big transformation had happened in the banking system with regard to corporate and long term loans. When term lending institutions like the IDBI, IFCI, IDFC and ICICI were lending for project loans, the banks were wary of long term loans and were focussed on working capital loans. After the advent of inventory financing, future toll/receivable financing, many private and PSU banks moved to this asset class over the past 10 years; also, they moved into home finance which has a longer tenure, whereas their deposit portfolio is of lesser duration. Many of the road and power projects were done through Special Purpose Vehicles without sufficient capital, and banks started lending to these projects due to targets and good fee income potential. Term lending institutions lost their importance and ICICI/IDBI became universal banks, and commercial banks started embracing large ticket long term loans.

When some of the projects got delayed or cost overruns occurred, the banks started providing support in some other name or to an associate firm or a company to tide over the NPA norms. This resulted in layering of NPAs; in fact, many a time, classifying a customer as NPA was used by banks more as a threat, but once classified as NPA the customer would not cooperate. In fact he would be happy, as he would get enough time to cheat the system, as the legal process took a long time. In the meantime many of the customers would strip the company’s assets and make it unattractive for anyone.

Loans against properties (LAP) became a new product in banking parlance and many IT parks, malls and other infrastructure projects came into being with this new product. But if the mall is not functioning profitably and the anchor tenant also vacates, there would be no alternate tenant to occupy, resulting in cash flow mismatch.

The recovery process is time consuming and the long drawn out process was helpful for defaulting borrowers. Wherever properties are mortgaged, banks could recover through the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act 2002, otherwise the working capital assets were either sold/disposed of by the borrowers before the banks take charge. What is required now is not a new legislation but committed legal reforms with a timeline to dispose of the banks’ claims through special courts. In other words, more functional and effective debt recovery tribunals across India.

Many of the leading PSU banks have brought in e-auctions to dispose of the assets under their control but the response has been poor, even for residential properties. In the case of retail loans, banks, in order to achieve stiff targets, have given up some underwriting standards, leading to frauds that end up in NPAs.

So far banks adopted a policy known as 'extend and pretend' to practise 'evergreening' of assets, which meant they did everything possible to ensure that loans given to favoured corporate houses were not classified as non-performing assets. And how did the banks successfully hide the magnitude of the problem? Through methods like corporate debt restructuring (CDR), strategic debt restructuring (SDR), joint lenders forum (JLF), 5/25 loan schemes, etc.

The banking system lost over Rs 7,000 crores a few years back when the Andhra Pradesh government brought in many hurdles in the path of micro finance companies to run their business and all the five leading MFIs went under, creating NPAs in the books of the banks. A bill was brought in to regulate MFIs which is still not passed by Parliament, and it may not come up for many years. After a few years gap, the MFI industry has again come up to higher levels of exposure, but the risks remain in the industry, that most of the loans are revolvers and interest rates are still hovering around 24 pc pa.

With commodity prices being low and exports not showing up, many of the small and medium scale enterprises are impacted by the cash flows and volumes. The capacity utilisation is not more than 60 pc in most of the large industries. The ease of doing business is a talking point today but in reality, the industries are suffering.

The interest rates for SME/MSME borrowers have not declined though the RBI in the past year had reduced their bench mark rates by 1.25 pc.

Power sector reforms as well as coal sector reforms are good but new investments are not happening and banks are not seeing turnaround stories. For the discoms, the government had worked out the UDAY scheme, but how are the banks going to get the benefit? It will only be a further burden on banks.

Due to poor monsoon for the past two years, the agriculture sector is not doing well and rural income levels are very poor resulting in agri loans being defaulted. There has been no effective Crop Insurance Scheme for the farmers (an interest subvention scheme is available) and many of them were exploited by the middle men and hoarders. The remunerative prices for pulses, sugarcane, rice and other commodities are not paid in time, resulting in NPAs of agri loans. Many of irrigation projects were not completed due to political interference.

The real estate sector is affected due to non-availability of finance from banks and after the blocking and enforcement of black money routes, they are not able to have cash flows to complete the projects in time, resulting in non-payment to banks. Though the prices of finished real estate projects are very high, the promoters have locked in good investment in land parcels which they cannot encash due to sector weakness. Many of the builders are resorting to financing via home loans from their buyers, which is worrisome due to the execution risks.

Is there then any way to resolve the NPA issue?

The government cannot continue to borrow and invest in banks’ equity in the years to come. They have to look at options for convertible bonds or long term sources from the World Bank/BRICS Bank for capitalisation of PSU banks. Or try a unique model of issuing tax-free bonds for capitalisation, as they had done in the case of Unit Trust of India for its Unit 64 scheme. Similar to getting cheap funds for the bullet train project recently, the government should look at Japanese government/banks for funding PSU banks.

Apart from capitalising for the NPA gap, growth capital would be required for sustainability. A systematic consolidation of banks is a must going forward, with new competition and disruptive products/players coming into the banking scene.

Banking will remain but I wonder whether PSU banks will remain!

Subramanian MV is a retired banker.