BS Banking Annual 2018: The worst may finally be over

Ailing banks, especially public sector banks, appear to have put many of their problems behind them

In the past few years, bank chiefs have repeatedly asserted “the worst is over”, only to produce more lemons and sloppy numbers in the next quarter.

After a batch of emphatic bank chiefs retired uttering these words, their successors were more circumspect, preferring to say “we are nearing the end”. They were disappointed too, as Reserve Bank of India (RBI) auditors unearthed more bad debts than the bankers would have wanted their investors to believe.

Bankers faced the RBI’s wrath for hiding bad debts, and a few had to leave their positions after getting roughed up by the regulator. Some three years after the central bank started the asset quality review (AQR), bankers are wiser now.

“Whenever we use this phrase, usually that quarter is bad with something different. We are now fed up of making this statement,” said Union Bank of India MD and CEO Rajkiran Rai G.

It is perhaps ironic then, that though bankers are actually in a position to declare “the worst is over”, they cannot yet muster the confidence to do so. There are enough indications, however, that the worst is over. 

The clean-up act

Handling of the bad assets situation, as was envisaged by then RBI governor Raghuram Rajan and the National Democratic Alliance (NDA) government in 2015, had four Rs — recognising non-performing assets (NPAs) transparently; resolving and recovering value from stressed accounts through clean and effective laws and processes; recapitalising banks; and reforming banks through the PSB (public sector banks) reforms agenda to make them responsible and responsive.

“The results of government’s comprehensive 4Rs approach are now visible,” Finance Minister Arun Jaitley declared in Parliament.

With Vijaya Bank and Dena Bank being merged with Bank of Baroda, the government is also moving towards the PSB reforms agenda, even as much still needs to be done, particularly on the compensation front. The elusive disinvestment in public sector banks, however, now looks to be a distant possibility. 

Bankers and RBI officials are now fairly certain that at least the “recognition” part is over. This doesn’t mean that there won’t be any bad debt accretion, but most of it will already be anticipated by the banking system, or arise out of the normal course of business.

“As far as the NPA cycle is concerned, March 2018 was the peak, and after that we are seeing a decline in the overall NPA cycle. Our bank’s balance sheet is now much stronger than what it was,” said Rajnish Kumar, chairman, State Bank of India.

The bad debt mess 

The AQR exercise, initiated by the central bank in 2015 to clean up bank balance sheets and fully provide for stressed loans, unearthed a huge amount of bad debts. Stressed accounts were reclassified as NPAs.

As a result of recognition of stressed assets as NPAs, gross NPAs of PSBs shot up from Rs 2.17 trillion at end-March 2014 to Rs 8.45 trillion at end-March 2018. 

But NPAs of PSBs started falling after March 2018, and stood at Rs 8.26 trillion at end-September 2018. Yet, bad debt is much higher than the PSBs’ net worth, which was Rs 5.75 trillion as on September 2018. The amount of stress due to wilful defaulters was Rs 1.47 trillion, Jaitley revealed. The RBI’s stress test shows that the asset quality of Indian banks will improve in March this year. The gross NPA ratio of all banks may come down from 10.8 per cent in September 2018 to 10.3 per cent by March 2019. This could further fall to 10.2 per cent in September, according to the RBI’s Financial Stability Report for December. (See Chart 1) 

It is also a relief for the economy that NPAs started falling for the first time in three years since 2015. Recovery has improved after the introduction of the Insolvency and Bankruptcy Code (IBC) because bankers say they are using it not just as a recovery tool but as a means of bringing promoters to the table to pay up.

“After a prolonged period of stress, the banking sector appears to be on course to recovery as the load of impaired assets recedes; the first half-yearly decline in the gross NPA ratio since September 2015 and improving provision coverage ratio, being positive signals,” said RBI Governor Shaktikanta Das in the foreword to the report.

Asset quality remains uncomfortable nevertheless. PSBs were the worst affected, mainly because they were the ones who participated in the credit boom between 2006 and 2011, when credit grew, on average, at 20 per cent a year.

Banking sector credit growth has started picking up. At a year-on-year growth of 15.1 per cent, it is much higher than 10.1 per cent a year ago. This is despite 11 PSBs remaining under the RBI’s restrictive prompt corrective action (PCA) framework. This indicates that some banks have indeed become aggressive lenders, picking up the tab for those that are not lending.

Most of this growth is driven by retail, as banks seek to avoid the risks of lending to the corporate sector. Just 12 large accounts of banks constituted a quarter of the total bad debt, indicating the need to avoid large accounts. But bankers say the retail portfolio could start showing stress as well, as that is the usual cycle. 

Meanwhile, micro and small enterprises have started piling up bad debts. Analysts are also cautious about the stress in agriculture due to the culture of loan waivers. 

“The delinquency base is still small in retail and the banking system can absorb that very well. But in agriculture there is a credit culture hit and despite subvention schemes, the portfolio is almost certainly going to see more stress,” said Prakash Agarwal, director, financial institutions, India Ratings. 

“In an election year the government may want to give relief in certain pockets of agriculture, but the expectation of credit relief is spread across all segments,” Agarwal said.   

Even as 11 PCA banks have stopped disbursing big ticket loans, they nevertheless remain vulnerable, with their legacy loan books. At the end of the September 2018 quarter, PSBs had a gross NPA ratio of 14.8, against the industry average of 10.8 per cent.

“In terms of the impairment of assets and earnings cycle is concerned, I would imagine we are very close to the peak,” said Romesh Sobti, managing director and CEO of IndusInd Bank. “A rough estimation is that may be about 80 per cent of the recognition has been done,” he said.

The total stress in the system could be near about 14 per cent of the advances. 

Provisioning and capital 

The next major step that bankers are concerned with now is provisioning. Much of the provisioning has been done, however, and as accounts age and bad debts reach the stage of writing-off, banks need to set aside the full amount as provision. That’s a humungous task, considering banks are suffering from low capital.

According to the RBI, in 2017-18, the total write-off for the banking system was Rs 1.63 trillion. Write-offs have declined in the second half of 2018-19, as recovery improved, the RBI report said.

Pallab Mahapatra, managing director and chief executive officer, Central Bank of India, said “Slippages have come down mainly in corporate loan books. Still, there is some struggle ahead for banks, especially in making provisions.”

Here, the new Indian Accounting Standards (Ind-AS), based on International Financial Reporting Standards (IFRS), are going to play a crucial role for the banking system, starting April 1. This will have a significant influence on the banking sector, primarily due to the changes in loan loss provision norms from a prescriptive basis to a more scientific assessment, such as expected credit loss.

“The change will be a step in the right direction, as it will lead to earlier identification and provisioning of NPAs through the use of forward looking factors (cash flow projections and macroeconomic scenarios), and the strengthening of risk management infrastructure across banks,” said Zarin Daruwala, head of Standard Chartered India. 

“The transition impact will be varied across banks, depending on their existing capital strength and provisioning practices. Banks that are facing capital and asset quality challenges will require additional provisions that will further impact their capital position,” she said, adding that the transition would be relatively easy for foreign banks, many of whom had already migrated to the IFRS regime last year in compliance with global reporting requirements.

The RBI’s fiscal stability report said 18 banks, including all 11 under the PCA framework, “might fail to maintain the required CRAR (capital to risk weighted assets ratio),” if the gross NPA ratio increased by four percentage points. These 18 banks had a share of 31.7 per cent of total assets of all banks.

“As many as eight public sector banks under the PCA framework may have a CRAR below the minimum regulatory level of 9 per cent by March 2019 without taking into account any further planned recapitalisation by the government,” the report noted.

So, bankers reckon, the next step after recognition is setting aside money to provide for bad assets. That is a costly affair, considering that Indian banks are capital starved. There are two ways banks hope to boost their capital — recover bad debts, hoping to keep haircuts at the minimum, or wait for the government to inject money.

Capital-starved 

Hitting the market to raise capital is a possibility, but the markets won’t be kind to PSBs with their bloated balance sheets. Banks do realise that.

Banks may also see challenges from the capital markets from the lending and borrowing perspective. On the one hand, corporates are increasingly borrowing from the market; on the other, more people are investing in capital markets, leaving banks less space to raise cheaper funds, thereby making them more dependable on capital infusion for growth. 

“Going forward, the banking sector could gradually lose its share of household savings intermediation to the capital market. The sector will have to focus on services and transaction banking. Retail assets with shorter durations will survive until inherent asset-liability issues are addressed, but housing finance and infrastructure finance will need government and regulators to make structural changes,” said Ashvin Parekh, a leading financial markets expert and managing partner of Ashvin Parekh Advisory Services. “Capital will continue to be scarce and dearer for banking,” he said.

Recovery of bad debt is a staggered process and takes time, even with such supportive laws as IBC, but direct capitalisation by the government is the surest way to boost up the ailing banks’ health. The government’s capitalisation exercise so far has helped, but much still needs to be done.

The government announced recapitalisation of Rs 2.11 trillion in October 2017, but it injected Rs 88,139 crore in PSBs in 2017-18 and made a provision of Rs 65,000 crore for the current financial year. Until November 2018, PSBs have been recapitalised to the tune of Rs 1.29 trillion through infusion and mobilisation of capital from the market, according to a reply by the minister of state for finance in Parliament. 

Considering PSBs control some 70 per cent of the banking industry, their capital is of paramount importance. Even as India’s banking industry looks adequately capitalised at 14.6 per cent as of June 2018, thanks to private and foreign banks, PSBs had a capital adequacy ratio of only 11.7 per cent, which further declined to 11.3 per cent at the end of September. This is barely manageable when the minimum required under the Basel III norms is 10.5 per cent.

A global comparison shows that our banking system needs more capital at the very least. Importantly, with the exception of China, most major global banking systems are run by private entities. So, in a comparison, even as India’s overall capital adequacy looks competitive, it is not so. For a comparison of the CAR of various countries, see Chart 2. 

The lack of capital can be compensated by recovery. However, so far banks have found it tough to recover their dues.

Recovery 

All this changed with the introduction of IBC in December 2016. Specifically, after the RBI’s February 2018 circular, whereby one day’s delay in servicing loans is considered a default, banks now have the power to drag any company to court to recover their dues in a time-bound manner. So far, banks have recovered money in only a few large accounts, but that may change this year, since many large companies that have burnt a hole in bankers’ pockets are up for sale.

Bankers have reason to be happy, and Sobti of IndusInd Bank explains why: “Twenty years ago if you threatened a borrower with a suit, he went and opened a bottle of champagne, because for 20 years at least you are not going to recover the money. Now, in six months you may lose your company. That is the best thing that has happened to banking.” 

Central Bank of India’s Mahapatra agrees: “The IBC has brought a lot of discipline in borrower behaviour. Borrowers are far more alive to obligations to repay dues.” 

“The first two quarters’ recovery figures are astonishing. Every rupee recovered is capital infused,” said Sobti.

However, these are early days; recoveries are not very strong. Banks have had to take huge haircuts.

RBI data showed that for the 701 cases now at the National Company Law Tribunal (NCLT), and claims admitted on 21 accounts for an amount of Rs 9,900 crore, recoveries are Rs 4,900 crore, indicating a haircut of about 50 per cent.

With Lok Adalats, 3.3 million cases yielded just Rs 1,800 crore, and in the case of the debt recovery tribunal, for 29,551 cases referred in 2017-18, the recovery has been Rs 7,200 crore. Under the SARFAESI Act, 91,330 cases have been referred, with recoveries amounting to Rs 26,500 crore. 

The government has asked banks to examine all NPA accounts exceeding Rs 50 crore “from the angle of possible fraud.” This means that banks will be much more aggressive in recovering loans. Much of that will play out in 2019. 

The government has also tightened the noose around wilful defaulters by deciding not to sanction additional facilities by banks or financial institutions, and debarring such defaulters’ units from floating new ventures for five years. Lenders have been given a free hand to initiate criminal proceedings against wilful defaulters wherever necessary.

Until September 2018, 2,571 first information reports were registered against wilful defaulters, 9,363 suits were filed for recovery from them, and action has been initiated under the SARFAESI Act in respect of 7,616 cases of wilful defaulters. Subsequently, the Securities and Exchange Board of India (Sebi) has also debarred wilful defaulters from accessing capital markets to raise funds.

Such defaulters also cannot participate in the insolvency resolution process. In short, bankers were never so powerful in recovering their dues.

“The approach of the banking system earlier was of rehabilitation, which became questionable. Now, we are not doing that. Now, it is simple if today your account is an NPA: Either you pay me, or I sell to ARCs, or I take it to the NCLT. Rehabilitation, restructuring — all that is out. It is not possible in today’s environment,” said SBI Chairman Rajnish Kumar.

However, there are chinks in the armour that need to be repaired. Some recent insolvency proceedings showed that bids were received from players that do not have the means to buy the companies concerned. This seriously undermined recovery proceedings.

The government also needs to fix the game that a few players are engaging in, which is to make a higher offer once the bid has been finalised and made public. While this may benefit banks, it seriously undermines the sanctity of the bidding process, say bankers.

Upcoming challenges 

“While Ind-AS is the single most impactful change in accounting standards for banks, there is also a material influence of the phasing in of Basel III norms that will add further capital requirements in the nature of incremental buffers (capital conservation buffer),” Daruwala said.

Non-banking finance companies (NBFCs), although remaining subdued now owing to liquidity tightness, will likely continue to pose serious challenges to banks. Their loan books are expanding fast and many are poaching the same good customers that banks target. According to RBI data, the total balance sheet size of the NBFC sector increased to Rs 26 trillion in September 2018, from Rs 22.2 trillion a year ago. According to Credit Suisse, about 25-35 per cent of incremental credit in the system is on account of NBFCs. This is the segment that bankers need to be careful about. However, they maintain that there is space for many more lenders.

And so, there are niche technology-oriented financial technology companies that are chipping away banks’ fee income. However, in terms of cornering significant market shares, these players are still some distance away, as banks have invested heavily in technologies that are on a par with or superior to some fintech providers.

Also, with the merger of three PSBs, the government has clearly stated its intent. The next biggest challenge would be to integrate these banks in a seamless manner. And if more banks are to be merged, which is likely, the government can move onto the next step of creating large Indian banks that can compete on a global scale. For that, though, bank boards have to be reformed considerably and lateral entries would be the norm, not the exception. Whether public sector banks and their owner are up for the challenge is a different story altogether.