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Jaimini Bhagwati: Indian PSBs - pitfalls ahead

Self-sufficiency in terms of capital adequacy is critical to improving performance

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The rallying cry for those in favour of the status quo in the when risk capital is sought to be raised is that “capitalism is in danger”. Bankers in the United States have added to worries about global growth by postulating that raising Tier-I capital requirements to nine per cent of risk weighted assets will lead to shrinking of bank assets and reduction in lending. The ’s stress tests on banks at the level of nine per cent Tier-I core capital, even with unrealistically low haircuts on and other , have identified several vulnerable European banks. Separately, a Financial Sector Assessment for China, conducted by the and the International Monetary Fund, indicates that there has been a “steady build-up of vulnerabilities” in the Chinese financial system “especially in real estate”.

In India, credit rating agency Moody’s recently downgraded State Bank of India () and placed the Indian banking sector under negative watch. In contrast, Standard and Poor’s (S&P) raised the Indian banking sector’s credit standing to place it in the same category as China, Turkey, Portugal and Thailand. From all indications, the international financial system is already quite fragile and capital flows to emerging markets may be decreasing. This article broadly reviews the performance of (PSBs) and suggests that a serious debate is needed on the capital requirements of PSBs, which need to increase lending to support growth.

On October 4, Moody’s downgraded SBI’s credit rating, on a stand-alone basis, from Ba2 to Ba3. According to Moody’s, its thinking was driven by SBI’s capital situation, which was relatively weak when compared to its “deteriorating asset quality”. Moody’s said that SBI’s Tier-I capital of 7.6 per cent, at the end of June 2011, was well below the average of 10 per cent for all Indian scheduled commercial banks. S&P’s more positive assessment probably took the government’s implicit guarantee into account. It has been reported that SBI may need additional capital amounting to Rs 30,000-40,000 crore over the next three years. Although SBI may have contemplated raising this volume of capital for some time, there was little information about this in the public domain before the downgrade. Of course, PSBs have to strike a delicate balance between providing accurate estimates of their capital requirements and not sounding alarmist.

SBI is listed on stock exchanges and investors expect timely information about its performance and need for capital. On November 15 this year, SBI’s share price stood at Rs 1,730, down 40 per cent from Rs 2,900 in December 2010. Incidentally, a deputy governor of the Reserve Bank of India () is still on SBI’s Board as per the SBI Act. This anomaly, the regulator serving on the Board of the regulated, should have been rectified by now.

The Indian financial sector is dominated by PSBs, and a close examination of the risk weighting of their assets and accounting norms does not get much public airing. In this context, the RBI’s annual report on “Trend and Progress of Banking in India” (November 14, 2011) and its publication “A Profile of Banks 2010-2011” (September 2, 2011) are not adequately analytical. Traditionally, close attention is paid to return on equity (RoE) as an indicator of corporate performance. However, return on assets (RoA), rather than RoE, provides a better idea of the sustainability of profits for banks. This is because banks can increase their debt-to-equity ratio to achieve higher RoE without any improvement in RoA.

The Table lists select performance parameters of PSBs and private banks. It can be seen that, in aggregate, private banks performed better than PSBs; the former had lower non-performing asset ratios, higher ratio of capital to risk weighted assets and higher RoAs. However, in defence of PSBs, they are required to meet priority sector lending and financial inclusion objectives, with little flexibility to address over-staffing or offer financial incentives. On the plus side for PSBs, the government’s implicit guarantee keeps their borrowing costs down and attracts depositors, and this benefit should be quantified. Although PSBs weathered the 2008 meltdown, the government has provided repeated capital infusions to several PSBs in the past. This could be attributed to priority sector lending targets. If profitability is adjusted for PSB capital used towards meeting social objectives and the benefits from majority government ownership, the performance of PSBs and private banks could be better compared. On balance, Indian private sector banks appear to have learnt their lessons from the 2008 crisis ,while PSBs seem to have become somewhat complacent.

STRENGTHS AND WEAKNESSES
PERFORMANCE INDICATORS OF INDIAN BANKS, 2010-11
  RoA
(%)
CRAR
(%)
NPA
(%)
Profits per
employee*
Number of
employees
SBI 0.71 11.98 1.63 3.85 222,933
Kotak Mahindra 1.77 19.92 0.72 8.00 11,337
Axis Bank 1.68 12.65 0.29 14.00 26,435
ICICI Bank 1.35 19.54 1.11 10.00 56,969
HDFC Bank 1.58 16.22 0.19 7.37 55,752
Citibank 1.37 17.31 1.21 28.61 5,327
HSBC 1.68 18.03 0.91 23.20 6,373
Deutsche Bank 1.95 15.03 0.23 43.37 1,453
PSBs  0.96 13.08 1.09 5.93 757,535
Foreign banks 1.74 16.72 0.67 27.59 27,968
Private banks 1.43 16.46 0.56 8.10 218,679
All SCBs 1.10

14.17**

0.97 7.00 1,004,182
RoA: Return on assets; CRAR: Ratio of capital to risk weighted assets (capital includes Tier-I and Tier-II capital as per Basel-II definitions. Tier-I capital includes equity plus disclosed reserves; Tier-II capital includes undisclosed reserves, subordinated debt); NPA: Net non-performing assets ratio; *Rs lakh; ** of which Tier I: 10% and Tier II: 4.17; PSBs: Public sector banks; SCBs: Scheduled commercial banks; Source: A Profile of Banks: 2010-11, RBI - 2 Sep, 2011

Given the importance of the banking sector to the economy, as storm clouds gather on the horizon of India’s growth prospects and the fiscal situation remains weak, we need to ensure that PSBs become self-sufficient in terms of . In this context, it would be useful if PSB performance, shorn of their financial inclusion and priority sector lending responsibilities, were to be assessed more explicitly in RBI publications. In particular, PSB risk weighting of assets, accounting and capital adequacy need to be increasingly referenced to norms and time lines indicated by the Basel Committee on Banking Supervision () — “Basel-III: A global regulatory framework for more resilient banks and banking systems”, June 2011. Further, the RBI’s report on “Trend and Progress of Banking in India” should provide more details about stress test scenarios and the impact on specific banks. Moreover, it should be published every six months instead of annually.

The author is India’s Ambassador to the European Union, Belgium and Luxembourg
Views expressed are strictly personal

j.bhagwati@gmail.com  

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