It is almost a truism that problems in the financial sector take longer to sort than those in any other segment of the real economy. A financial crisis can, at the very least, lead to a long-term slowing of growth. And, to defaults, affecting a wide range of sectors. It can even lead to a panic where banks fail. At the heart of the matter, all financial systems are unstable and ultimately based on public confidence. A currency is backed by nothing but faith in the system. Also, while fractional reserve banking is useful in that it creates a multiplier effect for money, it also means banks lend out anywhere from eight to 10 times as much as their owned funds. Meaning, they borrow many multiples of their net worth.
Under the new and stiffer Basel-III regulations, the Reserve Bank of India (RBI) will require commercial banks to hold net worth to the tune of roughly 12 per cent of total assets. That implies a bank will borrow 8.5 times its net worth. Or, that a few bad loans can push any bank to the edge of bankruptcy. Even a well-capitalised bank with solid debtors can be hit by liquidity problems if depositors want to withdraw money.
As of now, India's public sector banks (PSBs) are struggling. The RBI has set stiffer norms for recognising of non-performing assets (NPAs) and that led to a jump of a little above Rs 20,000 crore in these for the December quarter. PSBs now have gross NPAs of about Rs 3.06 lakh crore or just over six per cent of all their assets. The PSBs have provisioned for a fair proportion of those NPAs and the net NPAs, after provision, are at a combined Rs 1.75 lakh crore or 3.5 per cent of all PSB assets, roughly 1.25 per cent of the gross domestic product (GDP).
This is not the sum and substance of bad loan issues. PSBs also have about Rs 2.70 lakh crore in restructured loan dues. Usually, about 40 per cent of restructured loans go sour. So, another Rs 1 lakh crore or so in NPAs will arise from restructuring. In addition, the enhanced capital adequacy needs of Basel-III will require more equity subscription. That was estimated at Rs 1.80 lakh crore before all the bad loan slippages came to light. Now, it would be considerably more.
All of this will have to come from the Government of India, which has promised to find only about Rs 70,000 crore so far. It is now rumoured that the government will commit to trebling of recapitalisation, though even Rs 70,000 crore will be difficult to provide with the other calls on its funds. The market has recognised this. In fact, the stress on PSB balance sheets was always an open secret, though the dimensions might be even larger than pessimists had guessed. The difference between PSB and private sector bank valuations is stark. There are several ways to look at this situation.
First, the difficult state of the banking sector will significantly slow down GDP growth - it already has. Those bad debts are one reason why PSBs had not passed on the policy rate cuts of last year. Right now, it might not matter, as credit demand is low. However, there are some signs that this demand is indeed rising and the PSBs might not be able to meet it. There is, therefore, a logical case for revising earnings projections down. If 70 per cent of the commercial banking system is struggling, growth will almost certainly be hit.
Second, the government will certainly organise bailouts for PSBs, to the best of its ability. The market might be enthusiastic about these and, therefore, somewhat push up PSB shares. Turnarounds and potential turnarounds do get high valuations in every sort of market. On the other hand, unless there are radical changes in terms of giving PSBs the room to operate on purely commercial lines, they will continue to bleed. So, any run-up could be sharp but temporary.
Third, India's private banks look seriously over-valued. HDFC Bank, for instance, has twice the market capitalisation of European major Deutsche Bank. If there's a hint of 'infection' from rotten PSBs, or some systemic problems emerge within the sector, private banks could take a hammering.
In terms of timing, this situation might come to a head in the next three or four months in terms of policy decisions. There will be a great deal of volatility during that period, certainly for banking and other financial sector stocks, and for rate-sensitive stocks in general.
