NPA estimates: Street's optimism at odds with the RBI's pessimism

Regulator's projections higher by 250-350 bps, analysts may have jumped gun on faster recovery

Projections regarding asset quality in the banking sector have left the Street and Reserve Bank of India (RBI) divided. 

The RBI’s Report on Trend and Progress of Banking in India, 2020, published in December, reiterated the RBI governor’s opinion that asset quality woes may not be behind for banks, yet. The report captures the annual performance of the sector. 

However, the Street differs in its view, believing that the sector has performed better than expected, because of which the rerating in banking stocks (seen since October) does not defy logic.

To put things into context, the sustained rally in the markets has reversed the underperformance of the Nifty Bank index, which is now well in the green — up over 2 per cent year-on-year. 

While the big names in the private space — HDFC Bank, ICICI Bank, and even non-banking financial companies (NBFCs) such as Bajaj Finance and HDFC Ltd — are scaling fresh highs, even the relatively smaller names like IndusInd Bank, RBL Bank, and Federal Bank have recouped 50-80 per cent of the ground ceded in the past year.

In the past week, a host of foreign brokerages — Macquarie Capital, BofA Securities, Credit Suisse, and CLSA — have upgrad­ed their expectations on the Indian banking sector, citing the fast recovery and better-than-expected improvement in asset quality.

“We raise our earnings estimates by 16-35 per cent for private banks for FY22 and FY23, and 80-150 per cent for public sector banks (PSBs), driven by lower credit cost assumptions. On an average, we raise our target price by close to 30 per cent across the sector,” say analysts at Macquarie Capital. 

Brokerages are lowering their credit cost assumptions on two counts — fewer loans under moratorium to have come up for restructuring, and improving collection efficiency.

The question is whether analysts have turned optimistic too soon and too much. “The modest gross non-performing asset (NPA) ratio of 7.5 per cent, as of end-September 2020, veils the strong undercurrent of slippages. The accretion to NPAs — based on the RBI’s Income Recognition and Asset Classification norms — would have been higher in the absence of the asset quality standstill provided as a Covid relief measure. Given the uncertainty induced by Covid and its real economic impact, asset quality of the banking system may deteriorate sharply,” the Trend and Progress Report captures.

The extent of deterioration will be known in the Financial Stability Report (FSR),which is due this week. July 2020’s FSR estimated a rise in gross NPA ratio from FY20’s 8.5 per cent to 12.5 per cent under normal circumstances, and to 14.7 per cent in the worst case.

Assuming the forthcoming report doesn’t deviate significantly from the previous one, anticipated gross NPA estimates by the RBI are higher by 250-350 bps than the Street’s. 

The deviation may be on account of three factors. First, even as the Trend and Progress Report indicates system-level moratorium at 40 per cent, banks covered by analysts — including SBI and Bank of Baroda, among PSBs — have reported moratorium comfortably below 18 per cent. The same holds for well-tracked NBFCs. 

“Assuming stress is in the smaller names, a contagion affecting even the larger ones is likely thanks to the extent of interlinkages, and this is presently being ignored by the Street,” said a fund manager who remains underweight on banking stocks.

Second, as analysts at BofA Securities point out, there isn’t much clarity on the restructuring pipeline. Compared to the earlier estimates of 8-10 per cent, reports suggest that restructured loans may be less than 6 per cent of total loans — lower than even the moratorium number. 

Therefore, whether banks will treat fresh pain as NPAs upfront and provide for it, using the Covid buffer (1.3-3.0 per cent of total loans set aside), will be known soon.

Third, analysts seem to have skipped the point that without the Supreme Court’s standstill in Q2, NPA recognition would have been 10-40 bps higher for private banks and 20-60 bps higher for PSBs. With December being FY21’s first quarter with no restrictions on NPA treatment, the Street may have jumped the gun.

The fund manager quoted above points out that every time analysts downplayed the RBI’s concerns, they have been caught on the wrong foot. “We saw how the asset quality review of 2015 was initially regarded as a problem for just a few, but ended up consuming the entire system.”

While he believes money could continue chasing banking stocks, large domestic institutional players may use the opportunity to book profits.