When loans turn bad

Special Report

Though non-performing assets of banks have been on a rise in the June 2007 quarter, analysts are not alarmed as yet.

Over the past four year, the Bankex has gained 42.5 per cent a year, outpacing the Sensex annual gain of 39.4 per cent. The reason: Indian banks have witnessed a boom in credit growth which helped them balloon their balance sheets during the period. Even after such a rise in stock prices, demand for banking stocks is not going to wane given India's GDP growth, low penetration for retail products and corporates' hunger for credit to feed their expansion and acquisitions plans.

However, after RBI's monetary tightening measures to slow down credit and the rate hikes during the last 12-18 months, most banks have seen a rise in their non-performing assets (NPAs) in the recently concluded June 2007 quarter. So is this just a trailer of the imminent danger? Could it spoil the party enjoyed by the banking stocks?

Read on to find out what caused the increase in NPAs, what the outlook is and which banks are safer to bet on.

The cause
Rising interest rate scenario is the prime reason for the defaults. The hike in lending rates by banks was to maintain net interest margins following the monetary tightening measures adopted by RBI, which led to higher cost of funds. The Indian banking industry has witnessed a scorching pace of credit growth of 30 per cent in non-food credit for the past three consecutive years. This is due to the booming economy and rising demand for home loans and other retail products due to low interest rate scenario three to four years ago.

However, such high credit growth led to an acceleration in asset prices and inflationary conditions. In order to bring down the loan growth and cool off spiralling assets prices, the RBI adopted several measures like hike in repo rates (75 basis points), cash reserve ratio (200 bps) and increased weightage on sensitive sectors like commercial real estate and capital markets. And it has succeeded in this effort quite well. Growth in advances has come down to 24.6 per cent y-o-y in the June 2007 quarter from 30 per cent earlier.

Effect
In the June 2007 quarter, among the top 15 banks by market capitalisation, ten banks have reported an increase in gross NPAs (GNPAs) on a quarter-on-quarter basis both in absolute and percentage terms though half of them have reported a marginal rise. This is despite advances growing at a flat to declining rate. ICICI Bank, Axis Bank (earlier UTI Bank) and Punjab National Bank (PNB) have seen some of the highest rise in GNPAs. However, only eight banks have shown a rise in net NPAs both in absolute and percentage terms which indicates that these banks have provided enough for the default. On the net NPA front, along with ICICI Bank and PNB, Oriental Bank of Commerce have also shown one of the highest growth in net NPAs.

Sources
Industry experts and analysts feel that the deposit crunch in 2005, which led to a higher cost of funds, was partly responsible for the shift in portfolio by banks to high-risk and high-yielding assets like retail including housing and SME. Between FY04 and FY06, retail credit grew at 45 per cent a year and according to market sources, bank's lending to SMEs has also gone up. Says a senior official of one of the leading private sector banks, "Banks, who went gung-ho on retail and were lending recklessly to risky borrowers three-four years back are bearing the brunt now." Adds, Rupa Rege, chief economist, Bank of Baroda, "Export-focused small and medium enterprises (SMEs), which did not have major raw material imports, had to face a double whammy of declining realisations as a result of appreciating rupee and hike in their borrowing costs."

Should investors worry?
Analysts and mutual fund managers are quite unperturbed by the rise in NPA levels witnessed last quarter as they feel that Indian banks today are well equipped with adequate risk management systems. Says Sejal Doshi, chief executive officer, Finquest Securities, "NPA levels should remain at the current levels as housing, which forms about half of the total retail portfolio of the banking sector, and auto loans are secured by underlying assets." However, there are concerns of NPAs on personal loans and credit cards. Adds another analyst who did not wish to be quoted, "Defaults should not rise as interest rates are unlikely to go up substantially from the current levels." While Rana Kapoor, chairman, Yes Bank, also agrees that interest rates seesm to have peaked out. He adds, "Banks showing higher NPAs will witness one or two troubled quarters as they will be required to do some cleaning up." Says Rajiv Anand, head of investments, Standard Chartered Mutual Fund, "However, it is too early to get worried about it."

Which are the safer banks?
Analysts prefer banks that have performed consistently even in a challenging environment. Here are some banks they recommend:

HDFC Bank: The bank benefits from high CASA (current and savings bank deposits) ratio of about 57 per cent, stable net interest margins of 4 per cent and net NPAs of 0.4 per cent despite retail forming 57 per cent of the overall loan portfolio. The stock trades at 3.5 times and 3 times price to book value for FY08 and FY09 respectively.

Axis Bank: The bank has improved its CASA and NPAs though net interest margin declined marginally by 34 bps q-o-q to 2.7 per cent. The stock trades at 2.5 times and 2.3 times price to book value for FY08 and FY09 respectively.

Public sector banks like Bank of India (BoI) and Indian Overseas Bank (IOB): A track record of consistent performance in a challenging environment, reasonable valuations. BOI trades at 1.8 times and 1.5 times price to book value for FY08 and FY09 respectively. IOB trades at 1.4 times and 1.2 times price to book value for FY08 and FY09 respectively.