<b>Akash Prakash:</b> Stress tests for Indian banks

To calm investors, RBI must come out with a clear and transparent stress test for the major Indian banks


Akash Prakash
If bank shares are the proverbial canary in the global economic coal mine, then we should all be very worried. In Japan, banks have dropped by more than 10 per cent since the Bank of Japan (BoJ) decided to implement a negative interest rate policy. In Europe, banks' shares are down by nearly 18 per cent, compared to a decline of seven per cent for the Euro Stoxx index in the year to date. And in the US, bank shares are down 12 per cent compared to a six per cent drop for the S&P500. Emerging market-focused banks like Standard Chartered have been totally decimated, falling by 25 per cent in the last month alone.

Wherever we look, financials are leading the markets down. This underperformance reflects market fears around asset quality and exposure to falling commodity prices - but one also worries whether it is a leading indicator of dysfunctional monetary policy settings and a stalling global economy. One has learned very early on in life that, very often, where bank shares go the economy tends to follow.

If we apply this principle to India, then we should really be worried. Indian banks have been totally hammered, with most down between 35-50 per cent in the last 12 months alone. The markets seem so spooked by credit quality concerns that anyone with large corporate credit exposures has been smashed.

Just to give one a sense of how extreme this has now become, consider these data points. The entire public sector banking system (ex-State Bank of India) has a market capitalisation equal to Kotak Mahindra Bank. This is despite these banks having an asset base 30 times Kotak's. All the PSU banks together (including SBI) are worth less than HDFC Bank. ICICI has a market value less than Kotak Mahindra, and not even half of HDFC Bank.

The entire public sector banking system (including SBI) has a market capitalisation of less than $40 billion dollars. This is 70 per cent of our banking system. How can a $2-trillion economy be supported by a banking system so lacking in scale? Even in China, where the SOE banks have been de-rated and no-one believes their asset quality, things are not as bad as we see in India. The Chinese SOE banks have a total market capitalisation of $956 billion, compared to $40 billion for our PSU banks and a market capitalisation to total assets ratio of 5.8 per cent, compared to 2.7 per cent in India.

While one may wish to dismiss these valuations as being irrelevant and subject to the whims and fancies of the market, and policy makers may consider our stock markets to be irrational, they cannot be ignored for banks. Financials need capital to grow, it is their raw material; if markets are not willing to fund them they have no future. Market perception and the valuations given are of critical importance to banks.

These extreme dislocations in valuation are due to fear and lack of trust on the part of investors as to the true asset quality embedded in the books of the banks. It is currently fashionable to come out with some very large number as to the extent of impaired loans for the system. Many investors believe that the true extent of stressed assets for the system is upwards of 20 per cent of the non-retail loan book. Nobody believes that the restructured book will ever come good, or that 5/25 and strategic debt restructuring cases are anything but postponed non-performing asset recognition. There is growing fear around this whole process of rectification, which banks are not compelled to disclose. Everyone has some anecdote about ever-greening. Given the current legal framework, investors are very unsure as to what actual losses are, given default percentages. Should one just assume everything goes bad and has to be entirely written off?

One hears stories of the Reserve Bank of India (RBI) forcing banks to recognise certain assets, provide for some others even though they are in restructuring, create lists of problematic borrowers etc. There seems to be no clarity as to the RBI game-plan. Some investors feel that this is only the beginning, and we will see new RBI lists every quarter. Others worry about harmonisation - will the RBI enforce it despite in many cases differential security? What is the extent of provisioning the RBI has asked for? How big is the provisioning gap? There is a total lack of clarity. Uncertainty breeds fear and investors will assume the worst, especially in an environment as tough as today.

Given the above backdrop, it is to my mind in the interest of the system for the RBI to conduct a stress test for individual banks, with explicit assumptions. While the RBI does conduct system-wide stress tests for private, public and foreign banks in its bi-annual financial stability report, it has never given out individual bank-level data. It is to my mind imperative that the RBI do so immediately - at least for the private sector banks, SBI, and the Bank of Baroda, the idea being that these banks will be able to manage their capital needs on their own.

I suspect that in the case of the private banks they will not need additional capital, and even if they do, once the market understands and believes the extent of the hole if any, it will be willing to fund the capital needed. All the private banks, after taking out these legacy assets, are very profitable, with core domestic ROA's between 1.5-1.7 per cent. Similarly for SBI and BOB - they will need capital, but once the markets are clear as to the true and entire extent of capital needed, the government can work out a plan to sell non-core assets and raise capital. These two franchises will be supported by investors.

For the remaining PSU banks it probably makes no sense to disclose the stress test, for it may spook the markets - and, in any case, these banks will have to be capitalised by the government. They currently do not have access to the markets, until and unless we see greater systemic change in their governance.

There is currently a rush to the bottom, with each analyst trying to outdo the other in scaring investors about asset quality. The RBI must break this chain, and come out with a clear and transparent stress test for the major Indian banks. Most will not need capital. And once investors are convinced, the worst-case scenarios will come off the table and the pressure ease on their share price. The RBI's attempts to clean up the system are to be lauded, but it must help investors by laying out the true extent of the asset deterioration. Only then can the healing begin.

The writer is at Amansa Capital.
These views are his own

Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper

First Published: Feb 04 2016 | 9:50 PM IST

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