Moratorium verdict: Prepare for shock when a more realistic picture emerges

Loan Moratorium verdict: It also declared that compound interest will not be charged for the period of moratorium.

The coronavirus (Covid-19) pandemic led to many financial relief measures, which complicates the assessment of banking performance. The Reserve Bank of India (RBI) offered a moratorium on bank loans for the period April-August 2020. In September, the Supreme Court (SC) issued a stay order on a proposal to extend the moratorium. It also directed banks to not tag any bad loans as “NPAs” (Non-performing assets) until and unless the loan was already declared an NPA by August 31.

On Tuesday, the SC delivered a judgement where it refused to extend the moratorium beyond August 2020. It also declared that compound interest will not be charged for the period of moratorium. Presumably, banks will now have to reclassify NPAs.

At one level, this triggered a relief rally because investors feared that there would be complete relief of interest payable during that period. However, it also means that the March quarter results for the fiscal 2020-21 (Q4FY21) will probably show a sharp increase in NPAs.

The Q3FY21 results showed an economy in the early stages of rebound. Banking delivered one of the better performances. A sample of 34 listed banks registered net profits of Rs 30,689 cr on revenues of Rs 4.01 trillion. In the same quarter of the previous fiscal (Oct-Dec 2019), the same sample had net losses of Rs 6,058 crore on total income of Rs 3.63 trillion.

However, this performance doesn’t present the real picture. Credit growth (non-food) was low at around 5.9 per cent year-on-year (YoY), and banks also benefited from the lenient NPA recognition to dress up balance sheets.

In the latest Financial Stability Report (FSR Jan 2021), the RBI said: “This improvement (in bank financials) reflects regulatory reliefs and standstills in asset classification and hence may not reflect the true underlying risks. Macro-stress tests for credit risk show that SCBs’ GNPA (Gross Non performing Asset) ratio may increase from 7.5 per cent in September 2020, to 13.5 per cent by September 2021 under the baseline scenario. If the macroeconomic environment deteriorates, the ratio may escalate to 14.8 per cent under the severe stress scenario….  At the individual level, several banks may fall below the regulatory minimum of capital if stress aggravates to the severe scenario.”

The likeliest (baseline) scenario the RBI projects is, about one–seventh of assets could go bad. At the baseline, two banks may fail to meet minimum capital requirements (Common Equity Tier 1 Capital at 5.5 per cent of risk-weighted assets) by September 2021. This could happen to five banks in the severe stress scenario.

The moratorium was followed by a one-time-restructuring (OTR) scheme by the RBI. Taken together with the Stay order, in effect, loans gone bad during the pandemic could not be declared NPAs.

Estimates drawn from results of other financial institutions (which are reporting Gross NPAs) suggest an additional Rs 1 trillion turned NPA in 2020-21. High risk sectors include tourism and hospitality, MSMEs, aviation, etc.

Plus, a government-mandated Emergency Credit Linked Guarantee Scheme (ECLGS) has sanctioned Rs 2.46 trn of working capital loans to help Covid-hit businesses. Some portion of those loans – by definition, sanctioned to businesses in trouble – will also go bad. However these are zero-risk weighted to the extent guaranteed by the government.

Recapitalisation to the rescue

A sharp rise in NPAs will mean another round of recapitalisation, especially for public sector banks (PSBs). Between 2017-18 to 2019-20, the government put Rs 2.65-trillion into PSBs. It may be forced to exceed Budget estimates for Rs 20,000 crore of recapitalisation in 2021-22. The 2020-21 Budget made provision for a total sanction of a token Rs 2 lakhs and a supplementary demand released Rs 20,000 crore. Only Rs 5500 crore was actually disbursed to Punjab & Sind Bank.

The government’s PSB strategy consists of a mix of mergers and disinvestments. The FM said in her Budget speech that majority stakes in two PSBs will be sold (apart from IDBI Bank). There is a stated intention of reducing PSBs to five through divestments and mergers. According to press reports, two out of Bank of Maharashtra, Bank of India, Indian Overseas Bank and the Central Bank of India are likely to be disinvested in 2021-22.  Disinvestment will be difficult if equity prices are low since the realisations will be low.

While economic activity is picking up, Interest rates are likely to rise, given strong inflationary trends and the government’s own borrowing needs. Yields on government debt have risen. A scenario of rising rates is bad for banks - mark-to-market profits on existing portfolios will drop, and the demand for fresh credit may be negatively impacted as banks will also need to pay more for the cash they borrow.

Equity prices don’t reflect these risks. The prospects of disinvestment have kept speculators busy. There’s a sharp divide in terms of valuations and even price performance.

Valuations indicate that PSBs are valued at an amazing 68x PE (last four quarters), while private banks are valued at 34.5X PE. Since April 1, 2020, the benchmark Nifty has returned 78 per cent while the Private Bank  Index has returned 89 per cent and the PSB Index has returned 70.5 per cent. Be prepared for shocks as and when a more realistic picture emerges.