It may seem counter-intuitive, but lenders dislike a trend of rising interest rates almost as much as borrowers. First of all, rising rates reduce the mark-to-market value of any loans advanced previously at lower rates. They also choke off credit offtake volume. In a competitive lending environment, lenders are also compelled to hike their deposit rates, leading to pressure on spreads. Finally and perhaps most critically, rising interest costs make it difficult for debtors to generate enough profits to service outstanding debt.
India’s banking sector, especially the public sector banks (PSBs), has spent the last three years struggling to cope with all these issues. The Reserve Bank of India (RBI) has maintained a hawkish monetary stance since March 2010. The central bank has hiked the repurchase (repo) rate by a cumulative 375 basis points to eight per cent in the past 30 months and maintained correspondingly high reverse repo of seven per cent and a cash reserve ratio (CRR) of 4.75 per cent. The impact on growth and banking asset quality has been quite severe. Non-performing assets (NPAs) have swelled as a proportion of advances. While private sector banks have managed to hold the line in terms of NPAs, the PSBs have been badly affected. Most PSBs have seen their gross NPAs as a percentage of advances increase by anywhere between 50 and 150 basis points in the first quarter of 2012-13 over the fourth quarter of 2011-12. Net NPAs also show corresponding increases, and a trend of under-provisioning is evident. The majority of PSBs have cut their respective provision coverage ratios in 2011-12 and again in Q1 of 2012-13 in order to maintain an illusion of profitability. In addition to this, debt-restructuring requests have shot up. Restructured assets (which don’t count as NPAs) as a percentage of advances are reckoned to be somewhere around 5.5 per cent for the public sector bank universe in the first quarter of 2012-13. This is substantially larger than in Q4, 2011-12 (4.7 per cent) and even more compared to Q1, 2011-12 (3.9 per cent). Restructured debt is riskier — about 15 per cent of restructured loans eventually go sour. Restructured debt also fetches lower returns since banks cut their interest rates in the hopes of rescuing the principal.
The RBI is understandably worried. The Mahapatra Committee, which it appointed to examine the issue, has recommended that provisioning for restructured assets be raised to five per cent from the current two per cent. Public sector bank managements may not like the idea as this could drive their balance sheets into the red if it was adopted. However, the proposal for provisioning needs to be endorsed as it would give everybody a clear idea of the dimensions of the problem. This might also make it easier to structure bailouts as and when they become necessary. In practice, market valuations suggest that investors don’t believe the official numbers anyhow. The PSB segment trades at single-digit PE ratios, while their private sector competitors receive average valuations that are thrice as high. In fact, most PSB shares are available at fractions of their book value, which is probably even more telling. There are no signs the RBI is prepared to lower rates yet, giving all the affected parties a shot at turning things around. The capital adequacy norms under BASEL-III demand the raising of another round of Tier I capital, which will be difficult in the current depressed environment and because of the stress it would cause for the Centre’s finances. The sooner the PSBs bite the bullet and the Union government as their majority shareholder provides the necessary resources, the better it will be for India’s financial sector.