Key takeaways from the bad loans' clean-up

Public sector banks' need for capital should be used to make fundamental reforms to their governance and management, says Akash Prakash.

The third quarter of 2015-16 will go down as a watershed moment for the Indian banking system - when the Reserve Bank of India (RBI) forced banks to bite the bullet and face up to their asset quality issues.

No more hiding, no more pretending — banks, both public and private, were forced to face up to reality.

As a consequence, as reported by Business Standard, we had the public sector banks’ (PSBs) provisioning for bad loans hit Rs 44,000 crore (Rs 440 billion) in the quarter, double the figure of a year ago.

Eleven out of 25 PSBs reported a loss, with another eight reporting a drop in profit of 60-90 per cent.

All public sector banks combined ended the quarter with a loss of nearly Rs 11,000 crore (Rs 110 billion) compared to a profit of Rs 33,613 crore (Rs 336.13 billion) in the same quarter last year.

The total system-wide gross non-performing assets (NPAs) recognised stood at almost Rs 440,000 crore (Rs 4.4 trillion), a jump of 50 per cent - with the PSBs accounting for 90 per cent of these gross NPAs.

The average gross NPA ratio for PSBs was at 7.32 per cent, three times the level of the private banks, and this is without even considering the SDR, 5/25 and restructured assets.

The RBI and finance ministry must be lauded for having the guts to start this clean-up.

They have changed the narrative on the risk/reward distribution between the promoter and the banks.

By forcing banks to recognise losses, the RBI has ensured they have no choice but try to recover whatever they can from the industrialists.

While we are only partly done with the clean-up, with March 2017 being the target date for full recognition and provisioning, the path is now set.

The bankruptcy code is the next step in this journey, and that too will hopefully be in place this year.

We are seeing the beginnings of a much more level playing field for the banks vis-à-vis well-connected promoters.

The clean-up may hurt growth in the short term but will very fundamentally strengthen the system and our credit culture. The longer term payoffs will be immense - for both capital allocation and the ability to fund the next growth cycle.

So what are some of the key takeaways from the clean-up?

It is now clear that the markets were right. They never believed the PSB numbers and thus refused to recapitalise them.

Ultimately, the RBI had to force the banks to come clean. Having been lied to for years, it is but natural that investors don’t believe the government’s contention that after fully recognising all asset impairments no significant bank will breach its minimum core capital requirement.

Nobody believes that the capital the government has already committed to the PSBs will be enough to get them through the Basel changes, recognise their asset impairments and fulfill their growth needs.

If the authorities are so confident of their numbers they should disclose their assumptions. What is the true extent of asset impairment, and based on what stress assumptions?

How much is this hidden capital, property etc that the banks have? What are they assuming for loss given default?

How much of the restructured and SDR book are they assuming goes bad? What are the commodity price assumptions in their models? 

As I have written before, in the absence of data, markets will assume the worst.

Markets detest uncertainty. If the authorities genuinely believe that investors are over reacting and too bearish, then release the data of the AQR, let investors see the numbers and the assumptions used.

If there is fear that the numbers will spook retail depositors, that seems unlikely - as already in this quarter 11 PSBs have reported losses and the sector as whole reported a loss, but there seems to be no panic.

There can hardly be any political fallout as these bad loans did not originate in the period of the National Democratic Alliance government.

Why the hesitation to release the data? Investors will automatically assume that things are actually much worse than is being discussed.

We are going to need the markets to help us recapitalise the PSBs; the government does not have the money to do it all on its own.

In the absence of information on the true asset quality, investor support will not be forthcoming.

Bank of Baroda (BoB) was rewarded with a 25 per cent price spike after its earnings call, as investors felt it had come clean on asset quality.

Rather than slamming the stock further for the large write-offs, investors were happy to know the true picture and thus value the core franchise and factor in the legacy asset problems.

Greater clarity will allow investors to do the same for other large PSBs.

The second prerequisite for investor support beyond greater disclosure on asset quality is management change.

No one is going to give money to the management/governance framework which led to this mess in the first place.

BoB has to be the template. Bring in qualified individuals and give them an empowered and credible board to shield them from Delhi.

The finance ministry has talked of this, but it all seems to be taking too much time. Fighting vested interests is not easy, after all.

This is not a banking crisis. Our private banks are fine, most will not need capital, and those that do have access to the markets.

The PSBs are in trouble, undoubtedly, but the public sees them as backed by the government. There will be no retail panic.

This gives us the time and opportunity to clean up and reform their governance, management and culture.

Use their need for external capital to force change. This is a real opportunity to address an Achilles heel of our economy and set it fundamentally right.

The authorities must be commended for starting down this road of reform. The quicker, the better.

The writer is at Amansa Capital. These views are his own.