Banking sector: More of a crisis than opportunity

There are some positive signals, as NPAs are growing at slower rates and interest costs have fallen

The NPA situation is likely to get worse. The Reserve Bank of India's (RBI’s) Financial Stability Report projects gross non-performing assets (NPAs) could rise to over 10 per cent, or even 11 per cent of all advances in a worst case scenario by March 2018. In March 2017, about 9.6 per cent of gross NPAs were logged. Credit offtake declined to historic lows in March 2017, when credit growth dropped to 0.8 per cent for public sector banks and to 4.4 per cent overall, with foreign banks seeing credit shrink by 8.6 per cent. 

There are some positive signals. NPAs are growing at slower rates. As interest costs have fallen, spreads have improved. Many banks have diversified revenue streams. By March 2017, 36 per cent of operating income was from non-interest income. Fee income stabilised at just above 10 per cent of total operating income. Profits on trading securities have risen to over 10 per cent from about five per cent (March 2016). This is only sustainable in a benign interest regime. 

RBI ran a three-scenario set of multivariate stress tests on 55 banks using macro-economic variables, with an assumed baseline, a “medium stress” level and a “severe stress” level. The variables included GVA (gross value added) growth, inflation, interest rates, gross fiscal deficit, current account balance, exports, etc. Under the baseline, gross NPA may deteriorate to 10.2 per cent by March 2018. In the severe scenario, RBI estimates gross NPA could rise to 11.2 per cent.  

RBI says, “A severe credit shock is likely to impact capital adequacy and profitability of a significant number of banks”. The overall capital adequacy ratio (CAR) was at 13.6 per cent in March 2017. Depending on stress levels, 2 banks (baseline) to 6 banks (severe) could have CAR dipping below the required 9 per cent. One bank could see Tier 1 capital drop below the required 5.5 per cent of risk-weighted assets.  

RBI doesn’t name banks. But, these are all likely public-sector banks (PSBs). The real problems are on PSB balance sheets. That’s where the vast majority of NPAs lie. There is also concentration risk. Assume the top three borrowers of any given bank default; 12 banks would see their respective CAR drop below 9 per cent. Even if one top borrower fails, profit before tax may be wiped out.

The key sectors are infrastructure-related. About 34 per cent of all stressed loans are in power, transport and telecom, which are riddled with bad debts and stalled projects. Associated sectors like mining (21 per cent of all mining advances), cement (35 per cent), metals (46 per cent), vehicles & transport equipment (26 per cent), construction (25 per cent) are in bad shape. 

Demand in associated sectors depends on health and activity in infra. A turnaround in infra requires a big committed policy push from the political establishment to restart stalled projects and enable dead assets to be written off. It will require lenders to take big haircuts to recover some portion of principal. Banks, especially PSBs will also need mass recapitalisation.

This is clearly a crisis. Since stressed loans equate to roughly nine per cent of GDP, there is urgency. The political establishment has tried to speed up bad loan resolution with enabling legislation. RBI and Sebi have also improved the regulatory environment. But on the other hand, the write off of agricultural loans will further add to balance sheet stresses and that’s likely, given multiple farmer agitations.

Broad growth can only be sustained by a healthy banking sector. There must be sharp improvement in PSB balance sheets. Perhaps, the crisis is serious enough to trigger appropriate policy response. If so, this represents an opportunity since valuations of PSBs are low. On the other hand, it could be a catastrophe if it's not tackled well.