Optimism towards PSBs may not last

India’s public sector banks (PSBs) have been lurching from crisis to crisis for a decade and Non-performing assets (NPAs) have continued to mount. Banking NPAs amounted to over Rs 6 trillion (Rs 6 lakh crore) and counting by December 2016. That's approximately five per cent of GDP and roughly nine per cent of gross advances. 
 
NPAs expanded by about Rs 1 trillion in the first three quarters of 2016-17. Many PSBs are technically bankrupt with NPAs wiping out their net worth. If stressed loans (not yet accounted NPAs) are included, the outstanding bad debt rises to Rs 9.5 trillion (as of December 31, 2016), or close to eight per cent of GDP. Stressed loans have a high probability of turning into NPAs. According to an estimate by Credit Suisse, about 40 per cent of Indian corporate debt is held by companies with interest coverage ratios of less than 1.

 
Even private sector banks have seen rising NPAs. Care Ratings looked at a set of nine private sector banks. NPAs for this set increased to Rs 78,991 crore (March 2017) from Rs 26,455 crore (March 2015). But, the ratio of NPAs to advances stabilised for private sector banks, at around 3.9 per cent.  The bad loans problem is large enough to make this a full-blown crisis. The tardy justice system is one barrier to a clean-up. There is political interference too, in selective writing off of loans. PSBs are not allowed to work on purely commercial lines.
 

A new ordinance has come, on the back of multiple attempts to speed up NPA resolution. Banks already had the power to take over corporate defaulters and sell off companies. Now the Reserve Bank of India (RBI) can coerce member banks to resolve NPAs quicker, especially in cases involving consortia. Let's see if this works.

 
NPAs are one reason why credit growth has dropped to what's said to be a 60-year low. PSBs have no money to lend. NPAs are also one reason why banks cannot pass on the policy rate cuts which RBI carried out during the Raghuram Rajan regime.
 
Sustained growth is impossible without adequate credit from the banking system. The BJP's economic strategy involves massive government expenditures on infrastructure and the encouragement of private sector investment in capital-intensive areas like manufacturing. After the political success of offering a big write-off of farm loans in Utter Pradesh elections however, the BJP may look to offer similar sops during the two years of campaigning leading up to general elections in 2019.

 
Bank stocks jumped when the ordinance came through. That was a knee-jerk reaction. In the cold light of day, whatever RBI does, and however smoothly the narrative is presented, there will be massive write offs. Following that, there will have to be massive recapitalisations. This will not happen overnight. It will not be painless.
 
The private sector banks have high valuations and can raise cash to meet Basel-III norms. But, the PSBs are trading at low values, including discounts to reported book value, in many cases. Moreover, the government cannot recapitalise as required — it simply doesn't have the money. Nor will it be politically acceptable to sell huge stakes.

 
Corrections in bank prices look rational. Shortselling PSB futures is a tempting trade. Unfortunately, PSB indices are not liquid and hence, cannot be used to hedge short positions in PSB stock futures. The Nifty Bank is very liquid but it's not a good index to hedge PSBs. Due to the free-float methodology, PSBs have low weight in the Nifty Bank.
 
Technical signals suggest that there may not be a crash yet since many PSBs are trading close to 52-week highs. But, when it does come, it could be a massive crash.