THE STORY OF India’s banking sector seems to mirror the fable of the ant and the grasshopper. As long as things were going well, banks were like the grasshopper, lending almost profligately. Now when the weather has changed, banks, like the grasshopper, will undoubtedly be saved—by the government and its army of taxpaying ants. Ask any banker (Fortune India spoke to several) and they’ll say the banks had a plan even when they lent indiscriminately. But then, as former world heavyweight champ, Mike Tyson, once said: “Everyone’s got a plan, till they get hit in the face.”
Banks may just have received the knockout punch, not just a fist to the face. The numbers tell a story of greed—and now fear. State Bank of India (SBI), the largest public sector bank, had gross NPAs (non-performing assets) of Rs 13,766 crore in the first quarter of FY14 from Rs 5,868 crore a quarter ago (the fourth quarter of FY13). The second-largest public sector bank, Punjab National Bank (PNB), a less dramatic climb in NPAs from Rs 2,957 crore to Rs 3,594 crore over the same period. Overall, the gross NPAs of 40 listed banks went up by 43% on an average in the space of a year; the total amount of impaired assets (restructured assets and gross NPAs as a percentage of total advances) in FY13 is at Rs 1.37 lakh crore.
A recent Credit Suisse report titled House of Debt states that the total debt of 10 well-known infrastructure companies alone accounts for 98% of the net worth of all banks. And these companies are in deep financial trouble. If these go down, their lenders are almost certain to take a severe hit on their balance sheets. It all sounds a bit like 2012 and the end of the world, but the numbers show that it’s not just another doomsday prediction.
Global ratings agencies are taking all this into account; Fitch has downgraded the viability ratings (an indicator of banks’ creditworthiness) of PNB and Bank of Baroda. In the case of the first, it was because the stressed assets accounted for 15% of its loans—the highest among public sector banks. Bank of Baroda, meanwhile, has foreign currency accounting for 50% of its loan book, which, given the current currency volatility, could mean an unstable credit profile. Moody’s has revised its outlook on SBI’s financial strength from ‘stable’ to ‘negative’.
WHILE THE STATE of the economy (falling growth, rising inflation, volatile currency, increased interest rates) may be responsible for some of the trouble banks are in, K.C. Chakrabarty, the Reserve Bank of India (RBI) deputy governor, in a recent speech, put the blame squarely on the banks for non-adherence to basic appraisal standards. Pratip Chaudhuri, the former chairman and managing director, SBI, adds that “banks did not have enough expertise to evaluate the technical parameters”.
The big problem, says Anil K. Khandelwal, former chairman and managing director, Bank of Baroda, is that banks unquestioningly accepted the due diligence (also called memoranda of information, or MoI in the trade) done by loan syndicators such as SBI Capital, IDBI Capital, and J.P. Morgan. “These [MoI] are accepted by the banks without much due diligence, ignoring the fact that they have been paid by corporates to get these proposals cleared,” says Khandelwal.
A Mumbai-based banker, who asked not to be named since his own bank deals with such loans, says banks like his often lend to large business houses. “The aura surrounding a big industrialist’s company plays a huge role in lending by banks, although the company may not be doing too well. Which banker would have the guts to reject a proposal coming from a large conglomerate, even though individual businesses may be incurring losses?” he asks. And that, he says, is why loss-making businesses such as “Kingfisher Airlines and Deccan Chronicle continued to get loans from banks despite their poor financial health”.
Other bankers Fortune India spoke with say it’s not just the big-name factor; it’s the fact that, very often, a chairman of the bank board joins one of these conglomerates on retiring from the bank. “It is these former chairmen who put a lot of pressure on their juniors to disburse additional amounts despite having huge debts on their books. The junior finds it difficult to say ‘no’ to a person who has been his boss for so many years. Look at the boards of large companies and you’ll see what I mean,” says another Mumbai-based banker with a large private bank.
But by far the biggest problem for banks today, and the one that could bring the sector to its knees, is the extent of lending to the infrastructure sector. Even three years ago, the government prodded public sector banks to lend to infrastructure companies. The government wanted to rebuild the country’s shaky infrastructure; banks were happy to lend in a booming economy—which grew by 8.5% in the go-go years between 2005 and 2010. For PSU banks, lending to large infrastructure businesses was more profitable than spending to chase retail clients where the sums were small and the competition far more intense.
In any case, private banks were aggressive in the retail space, and the PSUs were somewhat hobbled by the government’s insistence on focussing on priority sector loans. (The RBI defines priority sector lending as “small-value loans to farmers for agriculture and allied activities, micro and small enterprises, poor people for housing, students for education, and other low-income groups and weaker sections”.) So, long-term loans to large corporates was seen as both safe and profitable, because of the high valuations and ratings given by markets and credit-rating agencies.
“It was perhaps this unshaken belief in the unending growth trajectory of India that resulted in the precarious situation that banks find themselves in today,” says a former senior banker. He compares the state of Indian banks with those in the U.S. in 2005-06, when bankers believed that home prices would rise forever, and so lent indiscriminately, even to people with no visible income streams. All this came to light during the financial crisis (led by the housing mortgage meltdown) of 2007-08. “Indian banks, especially the public sector ones, also had a similar attitude and kept pumping in money to various players without doing adequate due diligence, in the misplaced belief that the demand for infrastructure would be unending,” he says.
Even before the boom years, infrastructure lending formed an important (albeit smaller) part of banks’ portfolios. Loans to infrastructure companies by PSU banks have been growing at an annual rate of 43.4% for the past 13 years—from Rs 7,243 crore in FY01 to
Rs 7.86 lakh crore in FY13, far higher than the growth
in lending to all other industries put together.
Even the global financial meltdown and its aftermath—between FY08 and FY13—had no impact on banks’ lending behaviour, with disbursements going up by as much as three times. The announcement of quantitative easing by the U.S. Federal Reserve (it would buy bonds worth $85 billion, or Rs 5.35 lakh crore, every month) and consequent inflow of funds into the Indian bourses helped banks, because it made raising capital easier—and more attractive—for the borrowers.
THEN CAME TROUBLE. The big infrastructure companies found that it wasn’t as easy to get green clearances (especially related to mining or construction) or even acquire sufficient land or water rights, as it was to get the banks to loosen the purse strings. Lack of fuel supply hampered many large power projects, and they were unable to manage the funds necessary to complete the projects. In the case of power producers, such as Lanco and GVK Power, state electricity boards were unable to pay for the power they bought, leaving these companies stuck with increasing debt on the one hand and unpaid bills on the other.
Add to that a deteriorating economy, a depreciating and volatile rupee, and stocks that are at all-time lows. For FY13, GMR Infrastructure had debts of around Rs 31,176 crore; GVK Power Rs 14,699 crore; Lanco Rs 30,798 crore; Adani Power Rs 39,806 crore; and Reliance Power Rs 21,387 crore; and Jaiprakash Power Rs 22,290 crore.
Similarly, their debt-to-equity ratios (an indicator of their ability to repay their debts) have worsened making them prime candidates for corporate debt restructuring. GMR’s ratio is at 2.8, GVK at 2.3, and Adani at 9.3; in financial terms, anything above 2 is cause for worry. These are among the biggest borrowers, and they are struggling to stay afloat. The number of large companies that have opted for corporate debt restructuring schemes has gone up from 10 in 2008 to 129 in 2013.
Gross non-performing assets and restructured assets have skyrocketed from
Rs 12,190 crore at the end of FY09 to Rs 1.36 lakh crore by FY13 (an annual growth of 83%) and many public sector banks have impaired assets that are more than their net worth.
A Macquarie report says these include Canara Bank (101%), IDBI Bank (109%), and PNB (124%) in the first quarter of FY14. The average for public sector banks is an astonishing 97%. Though the private banks are in a better position, they still have an increasing amount of bad debt.
In fact, many of the companies would have already been forced to restructure their debt, had the RBI not allowed special concessions and asset classification benefits “as a special measure with the objective of enabling the borrowers to tide over their genuine difficulties in a time of widespread economic and financial stress and help banks retain the quality of viable assets”, following the 2008 crisis. “Many of these companies had weak business models and would have collapsed but were given additional breathing space. But over time their weak fundamentals showed up and they started to get into trouble,” says another banker, not wanting to be identified.
The last 18 months have seen India’s economy deteriorate to such an extent that Ruchir Sharma, head of emerging markets and global macro at Morgan Stanley, and author of Breakout Nations: In Pursuit of the Next Economic Miracles, described India as a “breakdown nation” rather than a breakout one. A cocktail of judicial and regulatory activism resulting from “unfair allocation of natural resources”, a paralysed government with little capacity to push through reforms, high inflation and interest rates, and an uncertain and unfriendly tax regime have all worked to bring down GDP growth from 9% in FY11 to less than 5% today.
These developments have hit infrastructure the most. And that, in turn, has hit the health of banks. Unfortunately, things could only worsen in the coming years. According to a Morgan Stanley report, non-performing loans (NPLs) in the infrastructure sector could increase by 5%, and restructuring by 10% by FY15. That’s the best-case scenario. In the worst case, the consultancy’s analysts say NPLs could go up by 7.5% and restructured loans by 17.5%.
A senior official in the banking sector says the entire model of banks funding infrastructure projects is “fundamentally flawed because banks borrow short and lend long”—they borrow for two- or three-year terms, but lend for six to eight years. So, says the banker, “there’s an obvious asset-liability mismatch, which just gets compounded as time and cost overruns increase in terms of projects”. Many banks had hoped that take-out financing—infrastructure financing companies like Infrastructure Development Financing Corporation taking over the loans after a period of time—would help, but that never really happened because these companies themselves are reeling under debt owing to stalled projects. Of a total loan book of Rs 70,000 crore, IDFC has bad debts of around Rs 16,000 crore.
Ananda Bhowmick, senior director and head of financial institutions at credit rating agency India Ratings and Research, says: “The repayment schedule drawn up by the banks was faulty because it had no inbuilt flexibility while taking into account the kind of risks involved in taking large exposures in such long-term projects. They also had optimistic targets.” The specific infrastructure problem that he identifies is the fact that banks lend to state electricity boards as well as power generation companies—different links in the same chain. “If one develops problems, the other parts of the chain suffer,” says Bhowmick.
But it is not fair to make the banks the sole punching bags for the current mess. Part of the blame, says Khandelwal, also lies with “directors without accountability” like the finance ministry and RBI officials on the boards of various banks. “Why didn’t [these officials] raise any red flags when the situation was fast spinning out of control?” asks Khandelwal.
Interestingly enough, finance ministry representatives have taken themselves off the management committee of the boards of banks, which are responsible for all loan disbursements. “So, while it [the ministry] can give signals to the banks on who, how much and where to lend, it cannot be held responsible for any of the investments turning into NPAs,” adds a PSU banker bitterly. Similarly, he says, the RBI, which is the regulator of the banks, is the first to apportion blame, but it does little to prevent banks from going from one crisis to another.
EVIDENTLY, THERE'S LITTLE hope of the banks getting back the crores owed to them by infrastructure companies. So, here’s how the plot is likely to unfold: Banks will be bailed out by the government, simply because there’s no way the country can afford to have its biggest public sector banks fail. But with any kind of bailout, banks are going to find the going tough for the foreseeable future, and all risky lending will be tapered off.
Analysts, with the benefit of hindsight, say banks should have seen this coming. Bankers, however, say this isn’t fair. “You would have done sensitivity scenarios with 20% to 25% margins since you were financing 10-year projects, but you could never have visualised a complete ban on mining or the GDP falling off the cliff in just two years,” says Romesh Sobti, managing director and CEO of IndusInd Bank. These supply-demand scenarios were conceived with an economy expected to stabilise at 8% to 9% growth and not where it is today.
Srinivasan Vardarajan, executive director, corporate banking, Axis Bank, believes that banks got caught in an air pocket of multiple issues, compounded by a deteriorating macroeconomy. “A lot of these things get disguised when there is high growth,” he says.
A major part of the blame must lie with the government, chorus bankers. “Why did one department of the government issue so many licences knowing fully that Coal India did not have the capacity to meet the higher demand; or the Central Electricity Regulatory Authority dither raising tariffs, when cost of production was going up because of imported coal?” demands one.
We asked bankers the burning question: Banks will be bailed out by the government, but who will fund the next round of infrastructure projects in the country? Bankers say, for instance, although many power projects are struggling for a variety of reasons, there’s no doubt about the viability of the projects. So, they claim, funding will not really be an issue, however risk-averse banks become.
“The problem is with the organisations having to execute these projects. If an execution solution can be found, whatever that is, and the products priced correctly—the tariff setting is reasonable—they are not writeoffs,” says a PSU bank official.
There are also a few voices of hope in all the gloom. “I think that kind of doomsday prediction is not warranted. Unlike the dotcom boom, there are real assets on the ground, and once the issues are resolved, the projects will be up and running. Remember, these projects have life spans of 25 years to 30 years,” says N.S. Kannan, executive director and chief financial officer, ICICI Bank.
Adds Vardarajan: “Since no fresh capital investment or capacity addition is happening in the power sector, existing plants have a far better chance of being successful. The signs of revival are already there—whether it is the fuel supply agreements being signed, or the increase in tariff in various states. I am not saying that these projects are great, but their prospects seem better today.” And that’s more hope than most people in the industry seem to have.