The recent monetary policy announcements pertaining to asset quality and inflation would put pressure on the profitability of banks in the medium term.

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Banking stocks were fancied in the last four months on expectations of a revival in the economic prospects and improved profitability. However, things started to drift in the last two weeks. The big jolt came in the form of the monetary policy that was announced on October 27, wherein the RBI directed banks to provide for (maintain a loan provisioning coverage) at least 70 per cent of their respective non-performing assets (NPAs) by end-September 2010. While the move is seen impacting the sector’s profitability in the near- to medium- term as quite a few banks will have to set aside a higher amount towards this, it is also positive from a longer-term perspective as it will reduce their balance sheet risk.

The RBI’s move comes a week after rating agency, Moody’s, downgraded thirteen domestic commercial banks. Meanwhile, the declining trend in credit growth hasn’t shown any major sign of improvement; incidentally it is now at the lowest in as many as five years. But, economists believe that there are some signs of improvement. All these factors have accentuated the market losses for banking stocks in the last two weeks; more prominently since Tuesday. Post Diwali and till October 29, the BSE Bankex lost 12 per cent as against 7.25 per cent for the BSE Sensex. We look at the impact of these developments on the sector and individual banks, as well as the prospects going ahead.

A tough stance?
The latest move by RBI asking banks to increase their provision coverage to a minimum of 70 per cent of NPAs by the end of September of 2010 is seen impacting the profits of the banks. CRISIL estimates that the proposed minimum coverage for NPAs will mean that banks now have to make an additional provisioning of Rs 13,000 crore till end-September 2010—as on March 31, 2009, the NPAs were at 2.3 per cent of system advances, while the NPA coverage was around 55 per cent as on that date. Of the 35 banks rated by Crisil, 11 banks had provision coverage of less than 50 per cent and about 16 had provision coverage of between 50 per cent and 70 per cent.

Abhishek Agarwal, analyst, Religare Hichens, Harrison says, “We note that short-term ROE of banks may be hit, but sustainable ROE would remain healthy”.

The new provisioning directive however, means different things to different banks. Banks like ICICI Bank and SBI have a provisioning coverage ratio of around 50 per cent, while some others like HDFC Bank and PNB have a coverage ratio of 70 per cent or more.

CRISIL’s recent note says “The impact on the profitability of individual banks will vary. Since a bank’s provisioning is linked to factors such as the age of its NPAs, the available security, and its internal policy, there is a marked variance in the provisioning coverage ratios of banks.”
 

O P Bhatt, chairman, State Bank of India explains, “Over the past four-five, years we have seen that a large portion of our assets slide into the sub-standard category and slide back into the standard category”. He further adds, “When you execute a write-off, your provision coverage drops drastically, whereas if you don’t write it off and continue to provide for the asset your provision, the coverage remains high”.

If the provision norms are to be adhered to, estimates indicate that SBI would need to provide over Rs 3,800 crore by September 2010. This means that, in the short-term there could be an impact on the profitability. To give a hypothetical example, if the provision coverage was pegged to 70 per cent from its first quarter ratio of 45 per cent, the net NPAs would have reduced from the actual 1.55 per cent to around 1.35 per cent but net profit would have been around 40 per cent lower (compared to Rs 2,330 crore reported) in the June 2009 quarter.

However, we have not heard the last of this provisioning norm; some modifications might come along the way. Banks have requested RBI to allow loan write-offs to be treated as part of the 70 per cent loan loss coverage mandated by the regulator. In this regard, Agarwal says, “Further clarification is awaited on whether previously written-off assets would be adjusted while calculating the coverage ratio. If this is permitted, the additional provisioning requirement would come down further.”
 

Moody’s downgrades
Before, the monetary policy pronouncements, Moody’s Investors Service downgraded 13 Indian commercial banks on October 21, which is more due to systemic risks. Moody’s changed the systemic support input for Indian banks’ ratings to ‘Baa2’ from the ‘A1’ local currency deposit ceiling. Baa2 generally refers to moderate credit risk and indicates that the risk of a “system-wide banking crisis is low”.

This view is suggestive of highly supportive banking framework aided by the government through capital injections or merger with stronger entities. However, the global recession increased the level of stress in the Indian banking system, with the proportion of non-performing loans growing steeply, reversing the downward trend seen since the year 2000.

Experts feel that downgrades were obvious with the growth of restructured assets, but since most banks are well-capitalised, regulated and also have the support of the government, the downgrade is not worrisome.

Rupa Rege Nitsure, chief economist, Bank of Baroda, “Moody’s downgrade has to do with the size of our banking system in relation to the available resources with the government. This has nothing to do with the actual financial strength or soundness of our banks. The entire world knows that Indian banking has stood the test of time. Moreover, our banks have acquired immense strength as a result of the banking reforms since 1991-92. The ROAA of 1.13 per cent, the CRAR of 13.98 per cent and the net NPA ratio of 1.05 per cent for the Indian banking industry were not a mean achievement during 2008-09, when several global banks were crashing.”

Other policy initiatives
RBI raised the statutory liquidity ratio (SLR) by 100 basis points (bps) to 25 per cent, thus reversing the cut of 100 bps announced a year ago. Most commercial banks are maintaining around 27.6 per cent.

It’s not expected to affect system liquidity or earnings. “The SLR hike will not have any large impact,” says Chanda Kochhar, managing director and CEO, ICICI Bank. However, analysts expect that a few banks like PNB will need to step up SLR purchases to keep a buffer over mandatory SLR.

Besides, the general provisioning on commercial real-estate loans has also been increased from 0.4 per cent to 1 per cent. RBI increased the provisioning requirement in view of large flow of loans to this sector over the last one year and also increased restructuring of loans earlier in the commercial real estate. This move would drive up the borrowing cost for real estate companies and slow down credit growth of banks that have a larger exposure to this sector.

The monetary policy also saw the RBI up its inflation target for March 2010 to 6.5 per cent from the earlier 5 per cent. The banking regulator suggested that inflation was a major impediment. With RBI showing a hawkish stance, interest rates could see an upward bias indicating that the treasury gains seen by banks in recent quarters may not be sustainable.

Credit growth: Still low
Many experts also suggest that interest rates might have seen the bottom in the short-term. The worse will be if interest rates rise significantly, as it could prove detrimental for the economy which is trying to get out of the slump. The sluggish economy has already pushed down the overall credit demand.

A major segment of borrowers like corporates felt the heat as the manufacturing sector slowed down, during the course of the last year. In addition, certain banks exhibited caution to lend to retail sector. The deceleration in the credit growth was more prominent in the private sector and for foreign banks. Overall, bank credit has thus decelerated to 11 per cent as on October 2009 as compared to about 29 per cent in October last year. Lower credit growth means lower revenue growth for the banks, which along with lower growth in other income, will pull down overall growth.

The impact of lower credit growth was visible in the net interest income (interest income earned minus interest expended) that grew at a slower pace for many banks during the September 2009 quarter compared to previous quarters. In fact, six of the 11 banks reported a single-digit (or a decline) in their NII during the quarter. Had it not been for the robust treasury profits, the profitability of the banks would have been affected.

Banks like HDFC Bank, SBI and Union Bank of India are among those which have seen their profits rise at a faster pace than net interest income during the September 2009 quarter, mainly due to a spurt in other income. The good part is that many banks have also substantially hiked their provisions in the recent past, which provides comfort.

Although the credit off-take had been modest in the first half of 2009-10, a pick-up in the economic activity and increasingly willingness to lend more to retail (particularly auto and mortgage) suggest that bank credit could pick up in the other half. CRISIL expects overall credit to grow at an estimated 16-18 per cent in 2009-10, as compared with 17.3 per cent in 2008-09.

JM Garg, CMD of Corporation Bank, says “A demand pick-up, low interest rates and de-leverage in borrowers' balance sheets, should boost credit growth for the sector from second half of 2009-10, and we can grow higher than the system at around 22 per cent.”

Conclusion
For a long-time, and even during the last year’s economic slump, RBI has been proactive in ensuring banking system stability. It is probably looking at a situation of stress on asset quality continuing in 2010-11 after the restructuring window closes next year. Experts believe that despite the restructuring undertaken by banks in the past one year, their NPA levels are likely to rise. Crisil estimates that if NPAs rise to three per cent (now about 2.3 per cent), the banking system would require additional provisioning of Rs 20,000 crore. In this context, RBI’s move to strengthen the system by enhancing loan provisioning cover appears to be to a timely one.

However, the actual impact on banks may vary as several banks have requested RBI to ease or alter the stipulation. If these requests are taken favourably, it could be good news for banks like SBI and Canara Bank. Otherwise, RBI had asked banks to provide money over the next four quarters to provide a higher coverage for sticky assets, which would impact their profitability. Jyothi Kumar Varma, analyst, KR Choksey Securities, says, “We expect SBI’s and Canara Bank’s profit before tax to fall by 13 per cent and 15 per cent, respectively for 2009-10 and 11 per cent and 14 per cent, respectively for 2010-11.” The earnings pressure on account of higher provisioning banks like Canara Bank, Bank of India, ICICI Bank and State Bank of India, would impact ROEs. Overall, the outlook for the sector is not encouraging in the near-term, and unless the overall economic environment improves in a meaningful manner or the RBI relaxes the provisioning norms, banking stocks are likely to under-perform the broader markets. Among the preferred stocks include Axis Bank, Bank of Baroda, HDFC Bank, Union Bank and PNB, which investors may want to consider on dips.

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