The Banking Bubble

The ever-changing landscape of the financial world keeps on throwing facts that are more fictitious than fiction. Post sub-prime crisis, the best banks around the world were struggling for their survival. But many were able to swim out of it thanks to the life jacket thrown by their respective governments. Regardless, the Indian banks and especially Public Sector Banks (PSBs) emerged unscathed out of this financial calamity. The situation has however changed in the last one year and the economic downturn in India has taken a toll on these banks. At 12.6 per cent, restructured loans and gross Non Performing Assets (NPAs) form a significant part of the portfolio of Public Sector Banks (PSBs). On March 5, 2014 after a meeting with the top brass of PSBs, an unusually sober looking Finance Minister of the outgoing UPA Government offered a weak rationale for the poor asset quality of Indian banks. “One of the reasons why Non Performing Assets are high now is because NPAs are system generated,” the FM said implying that earlier with manual interventions, banks were not disclosing the true state of affairs.

The fact that the assets of PSBs are ridden with issues is an open secret and a cause of concern for all stakeholders. In this issue, we examine the scale and genesis of the current problem and the regulatory measures already taken to address it. We will also delve into what the investors should be doing with the banking stocks.

Scale of Problem

In the nine months ending December 2013, NPAs of United Bank of India (UBI) grew at an alarming rate of 297 per cent on a yearly basis. The fall out of such unusual rise in the NPA was on February 20, 2014, when the UBI chairman Archana Bhargava took voluntary retirement citing health reasons. Many in the market were caught off guard by UBI’s gross NPA figure of 10.82 per cent and the sudden resignation of the incumbent. There was also a blame game that the Core Banking Solution was not giving a true picture. The Reserve Bank of India (RBI) ordered a special audit. Meanwhile, the problem of fresh slippages is not idiosyncratic to UBI. The position of various bank groups as on December 31, 2013 is as under:

During the same period in which UBI nearly tripled its NPAs, fresh slippages in all PSBs grew 75 per cent. Three banks have fresh slippage of more than 200 per cent and in seven banks the fresh slippage is more than 100 per cent. The gross NPA levels in India’s largest bank, the State Bank of India, stands at a staggering 5.73 per cent of total advances as on December 31, 2013. Other major public sector banks like Central Bank of India and Punjab National Bank also have higher level of gross NPAs at 6.48 per cent and 5.40 per cent respectively.

Amongst the big names in the public sector, only Canara Bank seems to have gross NPA levels of less than 3 per cent. Bank of Baroda is on the borderline with gross NPA ratio of 3.3 per cent. Clearly, the SBI group and the Public Sector Banks have made some poor lending decisions, poor lending practices in the past and/or have not adopted effective monitoring mechanisms, which is reflective in their current asset quality. This also calls for increased provisions. Consequently, return on assets and net interest margin have declined in all PSBs.

On the other hand, it is surprising that new private sector banks have done exceptionally well in managing their balance sheets over the same period and their gross NPA’s are at 1.96 per cent. At 0.3 per cent, the net NPA ratio of HDFC bank is the lowest among all large banks.

Uday Kotak, the Executive Vice Chairman and Managing Director of Kotak Mahindra Bank in an interview pegged the overall size of troubled assets at `10 lakh crore (roughly 15 per cent of the overall loan portfolio). He noted that 30-35 per cent is completely non-recoverable. This means that to stave off a crisis, the Indian Banking sector will require nearly `3.5 lakh crore for recapitalization.

On the international map, the figure of USD 150 billion (INR 10 lakh crore) does look benign against the daunting figure of USD 2.2 trillion, the estimated size of Chinese non-performing loans (NPLs), which caused jitters in the global commodity and equity markets this week. While NPLs form merely 1 per cent of the Chinese Formal banking system, in the Indian context troubled assets forms over 10 per cent of the credit portfolio.

So Where Did The Problem Start From?

Shashidhar M Lokare of RBI in his working paper on Re-Emerging Stress in Asset Quality of Indian Banks has focused mainly on the Macro-Financial Linkages and has concluded that the first half of the last decade (2000-10) turned out to be a good period for Indian banks, with credit growth witnessing a sharp upturn on the back of high economic growth and NPAs growth trending down quite significantly. The second half of the last decade encountered a slowdown period in credit growth accompanied by gradual deterioration in asset quality, particularly by the turn of the decade. Accretion to NPAs, a critical indicator of efficiency in credit risk management, remained negative in most of the years prior to 2008 but expanded quite rapidly thereafter.

There is no doubt that the overall health of the economy has a major role to play in the worsening of the asset quality of the banks. From an 8.5 per cent GDP growth in 2010-11, the Indian economy has slipped down to 4.7 per cent in the third quarter of 2013. However, the problem is not systemic alone and its evidence comes when one compares the public and private sector banks. Since the advent of the global financial crisis of 2008, the financial health of Public Sector Banks has deteriorated quite dramatically. As already mentioned, the new private sector banks have done exceptionally well in managing their balance sheets over the same period. Within the group of Public Sector Banks, the performance of Canara Bank and Bank of Baroda appear to be better.

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Special Note - History of Non Performing Assets in Indian Banking

As we mull over today’s problems, it’s worth reflecting on how the Indian Banking Sector has evolved since reforms were initiated following the Narasimham Committee Recommendations in 1990 followed by another committee by the same name in 1998. As the graph below reflects, post liberalisation the 90s was a period of steady decline in the proportion of bad assets in the banking sector.

In order to give effect to the recommendations made by the Narasimham Committee, the Government of India set up the Expert Committee, headed by former Solicitor General of India, T.R. Andhyarujina in February 1999. The introduction of the Securitisation and Reconstruction of Financial Assets & Enforcement of Security Interest Act (SARFAESI), 2002 as a consequence of the recommendations of this committee, it enabled banks to take possession of the securities pledged by defaulting borrowers and sell them without the intervention of the court. The ensuing recovery and healthy global economic boom from 2002 led to a sharp decline in the percentage of bad loans carried forth by the Indian banks.

The tide turned quite dramatically in 2008 as global financial crisis loomed across the world. While the balance sheets of the US banks, where the crisis originated, are in a much healthier shape today, Indian banks are grappling with the highest year-on-year percentage growth in NPAs in the last two decades.

Amongst other things, poor lending decisions, unfinished infrastructure projects, mis-aligned incentives of the top brass and government are being touted as possible reasons for the recent increase in NPAs.

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Subprime? There Is No Subprime In India

The global financial crisis of 2008 was born out of high leverage in the banking system. The trigger for the crisis were mortgages made to risky retail borrowers that later became famous as subprime mortgages. Any attempts to find the subprime in Indian context are futile.

Over the past five years, banks retail and real estate loan portfolios have both held firm. The Retail NPAs have in fact gone down since 2011. Compare this to Corporate NPAs that have more than tripled and outpaced the NPA growth in Agriculture sector, which is colloquially associated with trouble in Indian Banks. The Indian retail sector continues to hold firm owing to rigorous screening standards and low levels of leverage amongst the Indian consumer. So, unlike the subprime crisis in the US where the problem was right at the bottom, in the Indian context the problems are right at the “top”.

Is Infrastructure The Achilles Heel Of India And Indian Banks!

It is well known that amongst all sectors, the problem of NPAs is worst in the Infrastructure sector. Within infrastructure, power, which forms over 55 per cent of the overall loans, is the worst hit.

The NPA levels in these sectors were fairly stable till 2012 and even decreasing due to massive credit expansion. In 2012, however, the sector started creaking and the NPAs grew at 70 per cent. Rising losses in the state electricity boards, and the shortage of fuel availability for power generation were the primary fundamental reasons behind the tumble of the power sector.

Also, there were delays due to environmental clearances and lackadaisical execution of infrastructure projects. A lot of these projects did not start generating revenues as a project. Many of these maybe healthy and profitable if executed in the long run, but the delays have turned these projects upside down.

The problem was obviously exacerbated when FED started tightening last year. The plethora of liquidity created by FED post 2008 found its way into the infrastructure sector of various emerging markets. Now as the cycle reverses, liquidity is being soaked up and the infrastructure sector has now become extremely vulnerable to liquidity issues.

The term structure of loans is thus a major factor to be accounted for while addressing the problems. The banks need to examine mismatch in their Asset Liability arising out of long-term loans. Bank deposits are generally short-term and the infrastructure projects are long-term. So, it may not be uncommon that many companies, in order to be eligible for bank finance window, dress their projections and the banks overlook this because the big-ticket advances to such projects builds their balance sheets.

Because of predated date of commercial operation, the projects become eligible for working capital which also is drained into project completion. It is not uncommon that the problems surface with the delays in project implementation and the deterioration in asset quality.

Besides the bank staff in commercial banks is not well versed in project appraisals for infrastructure financing and follow up. They are best suited for working capital finance. Project financing is best done by term lending institutions.

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Is The Problem Structural Alone?

While there is no doubt that there were structural issues, there is a whole angle of poor governance. A recent article published in Firstbiz (Santosh Nair February 2014), which features an anonymous interview with an erstwhile chairman of Public Sector Bank, narrates how the top brass is routinely arm-twisted to make lending decisions. To quote in his words: “Let me cut to the explosive points first, and then tell you the story of the conversation from the beginning.

• R discovered that many jobs of bank chairman involve bribing politicians.
• He found that from liquor barons to small businessmen, loans go bad because of political influence.

Little wonder, the banking system is now sitting on a volcano of bad loans”

All non-performing loans do not necessarily result from corruption; at the same time, not all bad loans are the result of a slowing economy. It is a combination of factors that causes a loan to go bad.

Shekhar Gupta of the Indian Express in his recent article (That’s what India Inc smells like these days if you can breathe through the pepper spray) narrates how a large number of infrastructure developers are ones with strong political connections and are amongst the most levered.

He presents the case of a highly levered infrastructure company that had over `35000 crore in debt and merely `1700 crore in equity. The debt was eventually restructured in 2012 by a consortium of 27 banks, giving the firm a reprieve on loans of over `9000 crore.

The political class has thus exacerbated the structural issues with a mixture of arm-twisting and poor appointments of the top brass.

So How Many Kingfishers Are Hidden In The Closet?

With debt of `7000 crore, Kingfisher Airlines is one of the biggest Non Performing Asset plaguing the Indian Banking Sector. Not even once since its inception did Kingfisher Airlines declare profits. In fact, after acquiring Air Deccan it suffered a loss of over `1000 crore. The aviation industry has seldom in the last sixty years been profitable, but one is still left wondering how the purportedly conservative Indian banks continued to lend to an airline with such poor financials.

Once the financial distress of the firm was perceptible, the consortium of 17 banks that had lent to Kingfisher made no attempt to restructure or orderly sell. Even today no asset-restructuring firm dares to venture close to the remnants of Kingfisher Airlines due to the political sensitivity.

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Is The Indian Banking Sector Equipped To Handle Large Loans This Size?

Even in absence of political pressures, one needs to closely examine the system in place in banks to handle loans of the size that were made in the past few years. While the large PSBs have all opened up special corporate branches, the managers running the show are not specialists in large ticket loans. Most of their careers have been spent assessing retail loans or at the most working capital requirements of the corporate sector and they probably don’t appreciate the nuances of complex corporate balance sheets for project financing.