Stressed and not showing: Covid-19 relief hides true picture about banks

Banks seem to be doing better as India's economy recovers from the Covid-19 devastation. But be prepared for shocks when a true picture emerges, writes Devangshu Datta

Third quarter results of Financial Year 2020-21 showed an economy in the early stages of rebound. Banking did better. A sample of 34 listed banks registered net profits of Rs 30,689 crore on revenues of Rs 4.01 trillion. In the same quarter of the previous fiscal (October-December 2019), the same sample had net losses of Rs 6,058 crore on total income of Rs 3.63 trillion.

Look deep though and there are signs that this performance doesn’t present the real picture in banking. While credit growth (non-food) was low at around 5.9 per cent Year on Year (YoY), banks benefited from lenient non-performing asset (NPA) recognition to reduce provisioning and dress up balance sheets.

“This improvement (in bank financials) reflects regulatory reliefs and standstills in asset classification and hence may not reflect the true underlying risks,” said the Reserve Bank of India’s (RBI) latest Financial Stability Report (FSR) in January.

"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,” said the report.

About one–seventh of assets could go bad, according to RBI’s likeliest (baseline) scenario. 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.

Banks' problems aren’t visible for several reasons. There was a moratorium till August 31, 2020 due to a nationwide lockdown to contain the spread of coronavirus pandemic. RBI’s one-time-restructuring (OTR) scheme followed the moratorium. In September 2020, the Supreme Court (SC) issued a stay order that prevented banks from classifying NPAs on any loans that had not already been declared so by August 31, 2020.

Taken together, in effect, loans that went bad during the pandemic could not be declared as 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. Some high-risk sectors include tourism and hospitality, MSME and aviation.

Plus, a government-mandated Emergency Credit Linked Guarantee Scheme (ECLGS) has sanctioned Rs 2.46 trillion of working capital loans to help businesses bit by the pandemic. Some of those loans—sanctioned to businesses in trouble—will also go bad. However, these are zero-risk weighted as they have government guarantee.

Hence, we’re seeing artificially low NPAs with a banking system under serious stress. A sharp rise in NPAs will mean another round of recapitalisation, especially for Public Sector banks (PSBs). From 2017-18 to 2019-20, the government put Rs 2.65-trillion into PSBs. It may be forced to exceed the 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 lakh, and a supplementary demand released Rs 20,000 crore. Only Rs 5,500 crore was actually disbursed to Punjab & Sind Bank.

The government’s PSB strategy comprises a mix of mergers and disinvestments. Finance Minister Nirmala Sitharaman said in her Budget speech that the government will sell its majority stakes in two PSBs (apart from IDBI Bank). The stated intention is to reduce the number of PSBs to five through divestments and mergers. According to press reports, 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 could be affected as banks will also need to pay more for the cash they borrow.

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