State of Indian Banks

State of Indian Banks

The recent order of the Supreme Court regarding classification of NPAs and payment of compound interest for the period of moratorium has reignited a debate on the state of Indian financial sector. The order of Supreme Court has been received by markets as a relief, as it removes a regulatory overhang and paves way for the banks to proceed with recovery of NPAs. Nonetheless, the next few quarters need to be watched closely for any precipitous rise in bad loans; especially if the recovery appears faltering.

Past few years have been quite challenging for Indian financial services sector. A decade of massive infrastructure building exercise (1998-2008) resulted in significant advancement of demand and therefore unviable projects in key sectors like housing, roads, power, civil aviation, metal & mining, SEZs, Ports etc. resulted in a multitude of stalled and unviable projects. Administrative and regulatory irregularities in allotment of natural resources to private parties led to judicial action, compounding the problem of failed projects. Demonetization (2016) and implementation of nationwide uniform Goods and Services Tax (GST, 2018) led to permeation of stress of MSME sector, especially the unorganized sector. The lockdown induced by Covid-19 pandemic (2020) further exacerbated the stress in this sector.

The process of recognition of the stress in sectors like infrastructure, metal & mining, telecom etc. started with changes in rules in 2014 & 2015. However, the real impetus was provided by implementation of Insolvency and Bankruptcy Code in 2017. The process started in right earnest with identification of top 12 (dirty dozen, 2017) non performing accounts by RBI and initiation of resolution process under IBC. Closer scrutiny of large stressed accounts resulted in collateral damage in terms of exposing of frauds and fraudulent lending at some NBFCs (IL&FS & DHLF) and Banks (Yes Bank, PNB, PMC etc.)

In past 4years, the process of NPA recognition and resolution accelerated; though not at the desirable speed. This entire process has resulted in emergence of some key trends in financial markets:

· Many weak banks have been identified. Some in public sector of these have been merged with relatively stronger banks. Some in private or cooperative sector have gone under rehabilitation (including management change) process.

· Most banks have resorted to raising fresh capital to strengthen their capital adequacy. The government has also provided fresh capital to stronger banks.

· Couple of large non banking financial companies (IL&FS and DHFL) have faced action under IBC. This resulted in massive losses to mutual funds who had been a major lenders to these companies. This has resulted in tightening of funding of NBFCs by mutual funds.

· The restructuring of perpetual bonds (AT-1) of Yes Bank, triggered a rethink on the risk profile of this important source of capital for banks; thus narrowing the window of raising capital for banks.

· In view of the elevated stress level, most banks have materially tightened the credit assessment standards. This has resulted in sustained slow-down in credit growth, especially to low rated companies and MSMEs.

· To manage the rise in deposits, due to fiscal & monetary stimulus and lower consumption during stressed times, many banks have resorted to increased emphasis on high margin personal loans. This trend threatens to put incremental stress on bank’s finances if the recovery falters due to relapse of pandemic or otherwise.

As per the latest Financial Stability Report (RBI, January 2021):

· Macro-stress tests for credit risk show that SCBs’ GNPA ratio may increase from 7.5 per cent in September 2020 to 13.5 per cent by September 2021 under the baseline scenario. If the macroeconomic environment deteriorates, the ratio may escalate to 14.8 per cent under the severe stress scenario.

· Stress tests also indicate that SCBs have sufficient capital at the aggregate level even in the severe stress scenario but, at the individual bank level, several banks may fall below the regulatory minimum if stress aggravates to the severe scenario.

· The overall provision coverage ratio (PCR) improved substantially to 72.4 per cent from 66.2 per cent over this period. These improvements were aided significantly by regulatory dispensations extended in response to the COVID-19 pandemic.

· At the aggregate level, the CRAR of scheduled urban co-operative banks (SUCBs) deteriorated from 9.70 per cent to 9.24 per cent between March 2020 and September 2020. NBFCs’ credit grew at a tepid pace of 4.4 per cent on an annual (Y-o-Y) basis as compared with the growth of 22 per cent a year ago.

· In the latest systemic risk survey (SRS), respondents rated institutional risks, which comprise asset quality deterioration, additional capital requirements, level of credit growth and cyber risk, among others, as ‘high’.

As per the rating agency ICRA’s estimates, gross NPA worth Rs 1.3 lakh crore and net NPA worth Rs 1 lakh crore were not recognized as of December 31, 2020 due to Supreme Court interim order. These NPA may get recognized in 4QFY21. A recent note ICRA mentioned,

“In ICRA’s outlook for the banking sector for FY2022, we had estimated the Tier I capital requirements for PSBs at Rs. 43,000 crore for FY2022, of which Rs. 23,000 crore is on account of call options falling due on the AT-I bonds of PSBs while the balance is estimated as equity.

“In the Union Budget for FY2022, the Government of India (GoI) has already announced an allocation of Rs. 20,000 crore as equity capital for the recapitalisation of PSBs. If the market for AT-I bonds remains dislocated for a longer period for the reasons discussed earlier, and the PSBs are unable to replace the existing AT-Is with fresh issuances, this would mean that the PSBs could stare at a capital shortfall based on the budgeted capital.

ICRA also expects that the GoI will provide requisite support to the PSBs to meet the regulatory capital requirements, which means that the recapitalisation burden on the GoI could increase, or the PSBs could curtail credit growth amid uncertainty on the capital availability. Apart from Tier I, as mentioned earlier, there could be reduced appetite from mutual funds along with a rise in the cost of issuing Tier II bonds as the limited headroom for incremental investments in Basel III instruments.”

In my view, the theme to play in financial sector may be “consolidation” and “market share gain” by the larger entities (banks and NBFCs) rather than economic recovery and credit growth. Attractively valued smaller entities may be vulnerable to extinction.

Author: Midas Finserve

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