Uncertain times ahead for banks

As interest rates rise, analysts expect an end to the benign asset quality cycle.

Banks seem to have fallen out of favour with investors and brokerages. After having delivered great returns last financial year, the sector is now coming under intense scrutiny of analysts. Several brokerages are advising clients to go easy on the sector, as return on assets and return on equity are likely to be capped. Given that rates are up 400 basis points from their lows, all eyes are now shifting to asset quality. The slowdown is likely to affect balance sheets of many companies.

With sectors like power, textiles and infrastructure facing their own unique problems, investors are worried about an increase in non-performing assets (NPAs). According to Credit Suisse (CS), historically, NPAs rise as loan growth slows and delinquencies are well correlated with rate increases (with a 12-month lag). Therefore in the next six months, CS expects an end to the benign asset quality cycle, which has been buttressing bank profitability even as net interest margin compression and treasury profits have weighed on top line growth.

A big reason for this negative view on banking is exposure to the power sector. Over the past three years, bank loans to this sector have grown 3x to $57 billion. Exposure of banks to this sector stands at 10 per cent of total loans. Analysts expect restructuring of some of these loans over the next 18 months.

Ambit Capital has undertaken a forensic accounting methodology to analyse on-and off balance sheet risks and the extent of profit and loss discretion they are exercising. The brokerage has found that amongst the new private sector banks, Axis Bank and YES Bank look exposed and Bank of Baroda stands out as the least risky. The findings show NPAs in the system are seldom reported as they should be. In particular, portfolio ever-greening and regulatory concessions tend to be used frequently to under-report NPAs. “Hence, the banking system’s reported numbers flatter to deceive. Further, based on our discussions with banks and based on the stories some of the banks have sold to our shareholders, we believe banks are adept at painting a rosier picture of their credit quality than the underlying reality.”

The NPA disconnect with reality begins with a bank’s attempts to prevent a borrower account from slipping into the NPA category through evergreening or through perpetual restructuring (tantamount to evergreening). Interspersed in the system are also banks that lack the capacity and perhaps even the willingness to identify NPAs in a systematic manner, resulting in a high proportion of discretion being exercised, especially in small-ticket loans that typically get shoved under the carpet. In turbulent times like these, investors no longer want to take risks of this nature.