Think of banks as barometers of an economy’s health, and India’s growth story is in peril. Most of the problems lie in state-owned banks that account for 70% of the banking system by assets. At the heart of the matter are loans that soured after a period of indiscriminate lending over the last decade. Many corporates, particularly powerful conglomerates, amassed huge debts owing to a combination of misfortune, miscalculation, and overambition. Mining ventures were hit by slumping commodity prices; and bankers’ optimism on infrastructure projects turned out to be hugely optimistic in bureaucratic India.
Former Reserve Bank of India Governor Raghuram Rajan recognised this lending bubble and forced public sector banks to admit their mistakes, setting a March 2017 deadline to cleanse their balance sheets of stressed assets. But most of them are in no position to meet that deadline; in fact, they are in deeper trouble now if anything. And this means all hopes of a neat resolution to the crisis will soon fade.
The malaise is reflected in the latest issue of Fortune India’s PSU 50 list—which ranks the country’s top 50 public sector units by gross profit. Eleven state-owned companies have dropped off the list, of which nine are banks. They include marquee names such as Bank of Baroda, Punjab National Bank, Canara Bank, Syndicate Bank, Bank of India, and Allahabad Bank.
Even the nine banks that clung to their place on the list have been scarred. For instance, the country’s largest lender, State Bank of India’s gross non-performing assets (NPAs) skyrocketed 147% to Rs 98,173 crore in March 2016 from Rs 39,676 crore in March 2012, forcing it to raise its provisions for bad loans to Rs 42,366 crore from Rs 23,858 crore. Higher provisioning led to profits dipping to Rs 12,743 crore from Rs 15,829 crore in the same period.
The major indicators of a bank’s profitability—return on equity (RoE) and return on assets (RoA)—also took a severe beating, turning negative in 2015-16. Loan recovery, meanwhile, hasn’t kept pace with rising NPAs. Public sector banks could recover only Rs 19,757 crore in FY16—a 29% fall from the previous year’s figure of Rs 27,849 crore. “There is a need to have a recovery-and-resolution preparedness (RRP) process in place for banks, which is clearly missing today,” says Rajosik Banerjee, partner, risk consulting, KPMG India. “It is an effective way for the management to identify and value the collateral received by the banks.” Moving to ‘risk-based pricing’, or offering different rates to customers based on creditworthiness, will limit such problems in the future, he argues.
The Insolvency and Bankruptcy Code, 2016, passed in May last year, will give banks power to foreclose on defaulting borrowers within 180 days, a huge advantage over existing legal solutions. “It will not only maintain the value of the collateral but also provide certainty of outcomes to the creditors,’’ says Krishnan Sitaraman, senior director, Crisil Ratings.
According to a Crisil-Assocham joint study, the move could potentially release about Rs 25,000 crore of capital locked up in NPAs over the next five years. It goes on to add that the bankruptcy law can help India’s banking sector catch up or even exceed the recovery rate of 32%, as well as the average time of 2.8 years in other emerging markets.
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The numbers paint a dismal picture. If one were to use stressed assets as a yardstick, many public sector banks may well be “technically insolvent” because their stressed assets far exceed the capital they own—the total bad loans of PSU banks today stand at 16.6% of their total loans. So if all the bank’s depositors wanted their money back at the same time, some banks wouldn’t be able to pay up. The situation evokes images of the snaking queues of panic-stricken people outside banks in Greece and Iceland following the collapse of their banking system in 2010 after the financial crisis of 2007-08.
The extent of the problem became apparent when Rajan decided to introduce an asset quality review (AQR) of banks in 2015-16. “The AQR brought to the fore significant discrepancies in the reported levels of impairment and actual positions, and hence, led to increase in the provisioning requirement for banks,” says the RBI’s ‘Report on Trends and Progress of Banking in India 2015-16’.
As a result of higher provisioning for bad loans, state-owned banks suffered losses amounting to Rs 18,000 crore in 2015-16. The reason: The AQR forced them to reclassify restructured loans—that could have become regular loans—as NPAs. This meant many such loans had to be written off and more money set aside to cover bad debt.
“The fear of the growing NPA menace has meant that the banks have frozen lending to the corporate sector,” says Rajiv Kumar, an economist, member of the RBI board, and senior fellow at the Centre for Policy Research. “This means commercial activity has virtually come to a standstill because 90% of the investment in the corporate sector is through the banking channel. The Indian corporate sector has limited financing options because the country’s corporate bond market has still not developed.”
To its credit, the government, along with the RBI, has displayed a willingness to air the financial system’s problems, but has had mixed success so far. For instance, the recently established Banks Board Bureau, headed by former Comptroller and Auditor General of India Vinod Rai, to help professionalise the boards of state-run banks, has failed to make a big difference.
Chief economic advisor Arvind Subramanian proposed creating a public asset rehabilitation agency, which would buy out bad loans and clean up the books of public sector banks, akin to the “bad banks” that have succeeded in reducing NPAs in countries such as Japan and South Korea. The government, however, has ruled out that route at the moment.
On Nov. 8, 2016, banks suffered another hammer blow when Prime Minister Narendra Modi withdrew Rs 500 and Rs 1,000 notes, about 86% of the nation’s currency stock, in a measure ostensibly aimed at combating black money, corruption, terrorism, and counterfeit currency. The move caused widespread chaos as banks scrambled to replace the old currency with new Rs 500 and Rs 2,000 notes. Between October 2016 and January 2017, deposits surged by Rs 5.6 lakh crore on which banks have to pay an interest of 4%. At the same time, credit offtake was only Rs 30,000 crore.
This happened when the Indian economy was already slowing, with credit growth clocking an anaemic 2.1% in 2015-16 compared to 7.4% a year earlier. Stagnant loan growth has squeezed net interest margins (the difference between the interest rates earned from lending and those paid out to depositors). In order to mop up the demonetisation-led liquidity spurt, the RBI increased the cash reserve ratio, which banks have to hold as reserves with the central bank and generate no returns, by nearly Rs 3.1 lakh crore.
As the majority shareholder, the government might have to bail out these embattled banks in a package similar to the U.S. government’s $250 billion (Rs 15.8 lakh crore) Troubled Asset Relief Program. “It must realise the enormity of the crisis that the banking sector is facing and act really fast,” says RBI board member Kumar. “Two things are vital: Clear the bad debts so that the banks can start lending again and ensure that the happenings of the past should not be repeated.”
It won’t be straightforward. State-owned banks also need capital desperately to comply with Basel III financing norms that India has promised to adopt by 2019. According to a February 2017 report by Ambit Capital, a Mumbai-based brokerage firm, public sector banks will require nearly $29 billion, or close to Rs 2 lakh crore, to meet their financing needs. State Bank of India itself would require nearly $4.2 billion, while Punjab National Bank would need $3.2 billion. The bigger and more profitable banks may be able the raise the necessary funds, but it would be an uphill task for the others. Ambit Capital has put a “sell” tag on all state-owned banks, “given the combination of muted earnings outlook and the recent run-up in their valuations”.
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According to the latest budget, the government plans to infuse fresh capital of Rs 10,000 crore into banks during FY18. This is much lower than the Rs 25,000 crore allocated last year, which was considered insufficient even then. The need of the hour is much greater and at stake is India’s economic well-being. The government can always raise finances for a bailout by monetising public sector assets such as selling state-owned land, says Kumar. “It not only needs to do so, but do so urgently. After all, the U.S. has done it and China has done it twice.”