Recast Overdue

Consider this:at the beginning of this year a big foreign broking house gave its projections about all the big banks including private sector ones in its research report on the banking industry. When the results started coming in, barring Corporation and Canara bank all projections were wide off the mark. The results of Punjab National Bank and a few others created a lot of consternation in concerned circles when they booked losses in stark contrast to the FIIs profit estimates.

How did this happen? Bank balance sheets are so opaque that you cannot figure out what is being hidden there. Starting from assets such as investment and advances to liabilities like deposits, you dont get to know the accurate figures and their break-up. Thus, in the absence of reliable data, all estimations are prone to errors. Moreover, banking is a very volatile industry where things change fast. This makes the task of prediction doubly difficult says Anoop Sethi, investment analyst, Jardine Fleming. This brings us to the problem faced by every investor in assessing the strength and profitability of a bank without transparent financial statements.

 

The ownership stranglehold

Why are banks financial statements not transparent? Historically, banks have been owned by the government of India which considers banking a sensitive sector. And any panic among the general public over the health of a bank may cause a run on banks and the whole financial system would suffer in such a case--this has been the popular refrain. Thus the access to information was restricted to the Reserve Bank of India and the Union government. Considering all this, financial statement proformas were drawn up by the RBI in a manner which do not reflect the accurate state of affairs of banks.

This, however, defeated the basic objective of a financial statement, that is, to provide information about banks financial position and performance. And thus banks operations remain largely shrouded in mystery till the bubble actually bursts. The cases of Bank of Karad and Indian Bank illustrate the point. In 1992, when changes were made in provisioning norms and asset classification on the recommendations of the Narsimhan Committee, a few changes were brought about in the banks financial statements too following the A Ghosh committee report. These changes were limited to separate disclosure of provisions and contingencies etc. Nothing more was considered, as the Union government and the RBI still remained the majority shareholders.

But over the past three years the ownership pattern in the banking industry has changed considerably. No more are the RBI and the union government the only shareholders of a public sector bank, as many banks--- even nationalised ones-- have decided to go public. SBI and OBC have already gone public while the Dena Bank issue has just got over. Bank of Baroda, Canara Bank, Corporation Bank and Bank of India are slated to tap the market soon. This change in the shareholding pattern has necessitated that all shareholders have equal access to informaton about the banks concerned.

Opaque on most counts

Keeping this in mind, how can bank balance sheets be further re-vamped to enable a potential investor to take an informed decision based on its statements?

To begin with, in the assets side of the balance sheet, the advances of a bank constitute its main business segment. Any analyst or investor would like to know the total advances of a bank, proportion of sticky loans, maturity profile of loans and sector-wise exposure. The figure of total advances is required to calculate the average lending rate and thus the average spread earned by the bank. The size of dud loans will indicate its health. But, to hide the quantum of dud loans, the Banking Regulation Act requires banks to subtract provision for dud loans from gross advances. The figure thus arrived at is called net advances which makes any attempt to calculate average lending rate and spread error-prone.

Let alone provision figures, even the break-up of standard, sub-standard, doubtful, and loss advances is not required to be stated in the balance sheet.. As banks worldwide, especially so in India, are widely suspected to conceal their true health by ingeniously converting bad loans into good loans, this makes the task of analysis extremely difficult. The current results of Indian Bank and Punjab National Bank etc.are cases in example. Investors further need details about sector-wise exposure to know the strength of bank advances. If the bank has lent heavily to, say, textile or acquaculture, that would reflect its vulnerability. Says Prabodh Agarwal, senior analyst, James Capel, This can only enable us to compare the strength of a bank vis-a-vis its competitors. He adds: Banks must at least provide some basic information like details of provisions, accounting policies, etc.

Some analysts like S R Krishnan of Pergerine India ask for disclosure of state-wise exposure of banks, as this would come in handy if a bank has heavy exposure in disturbed states like J&K or north-east. Another crucial point of disclosure should be the percentage of client exposure if it increases 15-20 per cent of the total net worth. This is considered significant as a problem with one major client can put the whole bank into trouble.

Investment is the second major business segment of banks which consumes 30-40 per cent of their funds. Here again, to assess the quality of investments, analysts need to know gross investments for the purpose of calculating average yield on investments. Balance sheets provide only net investment figures that are arrived at by subtracting provision for depreciation from gross investments. Says an analyst, Banks provide break-up of investments in two categories: permanent and current investments.

This break-up is of no help as it does not provide any idea of the kind of losses being hidden in the permanent portfolio. What we need are details about maturity profile and coupon rates of all investments. Then we can calculate the losses that will be booked by the bank in the future. And its only when this is taken into account, can the profit projections be worked out accurately. Moreover, the disclosure of the whole investment portfolio in broad categories at the moment is considered sketchy as important details regarding investments in treasury bills, commercial papers are not disclosed.

The assets side of the balance sheet further include banks losses which, a few analysts feel, should be subtracted from reserves and surplus and shown on the liabilities side. This is because losses are a fictitious item, and presenting them on the assets side creates a mistaken impression that these are working funds.

Grossly under-stated

On the liabilities side of the balance sheet, deposits are the most prominent item. Once again, no details are provided.

The strength of a bank is reflected not just by the quantum of its its deposits, but the investor profile for various categories and the maturity profile of these deposits. The maturity profile is important in that this helps identify the risk of potential asset-liability mismatches. In the absence of required information, investors are now forced to make conjectures over their assessment on the liquidity position of a bank. The details of deposits do not even reveal the quantum of certificates of deposit to enable assessment of the banks reliance on short-term deposits. Moreover, details about the proportion of rural, semi-urban and urban deposits are not provided which would otherwise have helped analysts to assess the possible maturity profile of deposits.

In the profit and loss statement, the figures for provisions and contingencies conceal more than what they reveal. The item includes:

Provision for depreciation of investment portfolio.

Provision for doubtful advances portfolio

Bad advances written off.

Provision for other

contingencies.

Provision for income tax.

Provision for interest tax, and nAmount set aside as secret reserves.

All these provisions are heterogeneous items. The first four items reflect the bad health of the bank because of poor quality assets. The next two items indicates that the bank is earning profits, and the higher the figure the better it is for the health of the bank. The last item is the most positive factor and shows high-earning capacity of the bank. As all these items are clubbed together, the result is one meaningless figure that does not serve any purpose, aver industry analysts.

The lack of uniformity in accounting practices is even more confounding. A few banks like Vysya Bank have taken the lead in provisioning separately for taxation. However, there is no consistency as last year a new private sector bank which went in for provisioning, has abstained from doing so this year. Says Sethi, Banks should separately disclose provision for taxation as without this figure one cannot fathom their tax planning and likely future tax incidence. For instance, Oriental Bank of Commerce invests heavily in tax-free bonds which means its tax-incidence in the future would also be less. All similar tax planning measures like leasing etc. should be separately disclosed so that we can make more accurate profit projections.

There are problems regarding accounting of these items in the balance sheet again. Provision for doubtful advances is subtracted from gross advances. Likewise, provision for investments is subtracted from gross investments and these items are shown as net figures. The rest of the provisions are clubbed under one head other liabilities and provisions` on the liabilities side of the balance sheet. This again, creates the same problem of heterogeneity as provision for income tax, secret reserves, expenditure like accrued wages, gratuity etc. are disparate items.

The Janus approach

Another grey area in the banks financial statements is of accounting policies which though governed by banking laws, central bank directives and general accounting principles and standards, is a constant hindrance to proper analysis. To take an instance, valuation of investments is made in accordance with RBIs directives which changes the proportion of the permanent and current portfolio every year. Furthermore, banks have the liberty of taking whatever quantum of investments they deem fit beyond a minimum ceiling in the current category.And if banks abruptly change their valuation policies like SBI did last year, all projections go haywire in such an eventuality. It could be made mandatory for such policies to remain constant for three years.

Accounting policies regarding revenue recognition is another contentious item. While OBC and HDFC bank balance sheets are silent on this front, Vysya Bank and Bank of Rajasthan provide some details. SBI and United Western Bank (UWB) disclose their policies in detail. However, their policies also differ in essence as SBI recognises locker rent on realisation whereas UWB recognises it on accrual basis. UWB recognises interest on debentures on cash basis while SBI does so on accrual basis. This reflects the need to standardise accounting policies across the board for all banks as this gives them leeway to manipulate their profit figures.

Depreciation polices again differ from bank to bank. OBC depreciates its leasehold properties on written down value method. SBI follows the capital recovery method to write off its lease assets, whereas Bank of Rajasthan adopts the straight line method. UWB follows guidance notes issued by the Institute of Chartered Accountants of India in case of leased assets under financial leases. Thus a matching annual charge is debited to profit and loss account as per the Companies Act and lease equalisation charge, respectively, representing recovery of net investment of the leased assets over the primary period.

Inter-branch reconciliation is another potential minefield as it might be hiding huge bank losses and frauds for years. Analysts demand that these should be cleared at the earliest by special initiatives taken by every bank management. Expense recognition is yet another area where few banks have framed their accounting policies. SBI books some part of staff expenses as per accrual basis and actuarial valuation. HDFC follows accounting standard 15 for recognising its staff expenses. While Bank of Rajasthan is silent on this, Vysya provides its on cash basis. Analysts feel that auditing standards of banks still need substantial improvement.

Vimal Jain, analyst with First Global says MAOCARO (manufacturing and other companies auditors report order) in refined form should be further extended to banks as in such a case bank auditors would have to report separately on adequacy of internal control procedures, internal audit systems, personal expenses charged to personal account, etc. Says Shailesh Haribhakti, partner, Haribhakti & Co, This year ICAI has set up a committee with RBI to harmonise accounting policy problems especially of foreign currency translation. From the next year onwards you would not see such different accounting policies followed by banks. Moreover, dramatic changes would be brought about by RBI in the next years financial statements so you will see disclosure of provisions and contingencies separately. But disclosure of advances--either industry wise or region wise-- that is not going to come.

Miles to go

How do such balance sheets compare with bank balance sheets internationally? Says Rupa Kudva, AGM, CRISIL, Abroad, banks financial statements provide detailed reports on the managements corporate strategy, its efforts to improve shareholder value and detailed commentary on what it seeks to do and how it views the current performance. Further, details of capital adequacy are provided.

This means that the complete break-up of tier I, II and III capital is given. On the advances side, details about industry-wise, region-wise, country-wise exposure is given.

Details of investment portfolio even include shifts in policy and reasons too for that. The management view on interest rate risk among other risks is given, with plans on how to tackle such risks. Quarterly results are declared. In addition to year-end figures, average figures for deposits, advances etc. are provided to expose the skew, if any. Off balance sheet exposures are stringent and include detailed discussion on derivatives, foreign exchange contracts etc.

Bandi Ram Prasad, chief economist, IBA demands, Every financial statement should carry sensitivity analysis as interest margins are reducing fast, affecting banks profitability.

Further, details about NPAs should be provided. In fact, it is necessary to include information about distribution of NPAs in notes to financial statements as this would reflect risk concentration of banks. Banks can even provide details of their shareholding pattern as this would be useful at a time when takeovers become more rampant.

It is evident that there is an immediate need to recast banks financial statements.The ball lies in the RBIs court. This recast, long overdue, would not only jolt banks into a level of greater efficiency but also make analysis of their stock market valuations more meaningful. And thats an imperative as more and more banks go public.