The poor results of India's private and public banks for financial year 2018 revealed a number of key concerns, but opinions differ on how to restore order. Rekha Menon reports.
The Indian banking sector continues to face challenging times. The number of bad loans is rising unchecked, placing immense strain on banks’ profitability and growth. On the other hand, high-profile banking frauds have put the spotlight on the gaps in banks’ risk management processes.
The recently announced results for financial year 2018 reflect the turmoil the country's banking sector is going through. Nineteen of India’s 21 state-owned public sector banks, which account for about 70% of the banking sector’s assets, reported losses both in the fourth quarter of the 2018 financial year, and for the whole financial year itself. Private sector lenders are also under stress, with Axis Bank, India's third largest private sector bank, reporting its first quarterly loss in the fourth quarter of the 2018 fiscal year. Overall, the banking sector made a net loss of Rs463bn ($7.1bn) in financial year 2018, compared with a net profit of Rs350bn during the previous financial year.
Bank performances were dented by the high provisioning requirements for surging bad loans, said global ratings agency Moody’s Indian affiliate, ICRA, in a recent report. “The sharp rise in fresh slippages, ageing of earlier non-performing assets [NPAs] because of limited resolution, and higher provisioning requirements on certain accounts referred for resolution pushed up credit provisions for the sector,” said the report. ICRA estimates that provisioning rose to Rs3170bn during financial year 2018, compared with Rs2030bn during the previous financial year, far surpassing the operating profits of the banks.
Fighting back
India’s bad loans problem can be traced back to the boom years of the mid-2000s that saw extreme corporate lending mainly by public sector banks, followed by an economic downturn and policy paralysis that stymied growth. The true extent of loan deterioration remained hidden initially, with banks opting to restructure a high proportion of their stressed assets. It was only when the country’s central bank, the Reserve Bank of India (RBI), initiated a systematic asset quality review in financial year 2016 that banks started accurately recognising NPAs. Subsequent RBI guidelines and audits helped further clean up bank balance sheets, while the Insolvency and Bankruptcy Code, with the National Company Law Tribunal (NCLT) as the adjudicating authority, created the institutional architecture for the time-bound resolution of stressed assets. However, concerns regarding banks under-reporting NPAs remained, and in February this year, the RBI radically overhauled the NPA framework by withdrawing various debt restructuring schemes and mandating stringent timelines for resolving large NPAs.
As expected, the NPA stockpile swelled. The country’s largest public sector lender, State Bank of India (SBI), saw its bad loans rise by Rs242.9bn in the fourth quarter of financial year 2018, compared with a rise of Rs139.3bn in the previous quarter. At the second largest public sector bank, Punjab National Bank (PNB), gross NPAs rose by Rs291bn in the fourth quarter of financial year 2018, while in the third quarter bad loans had declined by Rs1.1bn.
In February this year, a massive Rs130bn fraud was uncovered at PNB, which along with the high provisioning for bad loans, contributed to the bank reporting the largest quarterly loss by an Indian lender in the fourth quarter of financial year 2018. Private lenders such as ICICI Bank and Axis Bank, with high levels of exposure to the corporate sector, also saw bad loans rise in this period. On the whole, it is estimated that the gross NPAs of the Indian banking sector rose from Rs7650bn in financial year 2017 to surpass Rs10,200bn in financial year 2018.
Time for improvement
Today, India ranks alongside troubled EU countries such as Portugal and Italy for its comparably high ratio of bad loans, which increased from 9.5% in financial year 2017 to 11.8% in financial year 2018. Public sector bank IDBI Bank has the highest NPA ratio in the industry at 27.95%, while ICICI Bank has the highest NPA ratio among private sector banks at 8.84%. Most private sector banks, however, have remained relatively immune to the toxic loan crisis. Both HDFC Bank and Kotak Mahindra Bank, for example, have NPA ratios of below 2%.
Industry experts agree that the bad loans scenario in India is extremely grim. However, there is no clear consensus on how long it will take for the situation to improve. Banking industry consultant Ashvin Parekh says that NPA resolution might take up to two years. “There is a lot of overcapacity built between 2012 and 2017 that has not been properly utilised,” he says. “Industry recovery has not happened, while bankruptcy resolutions through the Insolvency and Bankruptcy Code and NCLT are still at early stages. It will take up to eight quarters for the banking sector to get back on track.”
Abizer Diwanji, partner and national leader in financial services at EY India, predicts that because of the RBI’s February circular, the upcoming September quarter will see more NPAs being reported. The value of stressed assets including NPAs and restructured loans currently in the industry is Rs15,000bn, according to EY. “It is a fairly bleak situation facing the banking sector,” says Mr Diwanji. “NPAs are increasing, many insolvency cases might not get resolved in time and NCLT courts might get overloaded. Corporate lending will slow down further and most banks will focus on the retail market.”
Rana Kapoor, CEO of private sector lender Yes Bank, is more optimistic. “The asset quality problem in the Indian banking industry, mostly a manifestation of past adverse macros, policy inconsistencies and inadequate risk appraisal, has now peaked, in my opinion,” he says. “While the RBI’s asset quality review brought about an end to the forbearance of restructured accounts that resulted in an increase in NPA ratios for the sector, this at a subliminal level was just a change in labelling of existing stressed accounts.”
SBI chairman Rajnish Kumar suggests that the worst is over. “The past year has been very challenging in terms of asset quality and provisioning,” he says. “The clean-up under the oversight of the RBI’s revised NPA framework was unprecedented. However, the silver lining is that NPAs have peaked in March 2018, the bankruptcy code is in place and time-bound resolutions are in progress.” Presenting SBI’s financial year 2018 results in May, Mr Kumar said: “If the past year was the year of disappointment, this year is the year of hope and then financial year 2020 will be the year of happiness.”
Capital shortfall
A key challenge for public sector banks, Mr Kumar points out, is the need for capital, especially for distressed banks. The RBI has placed 11 public sector banks under prompt corrective action (PCA) on the basis of their financial parameters falling below the risk threshold set by the regulator. Banks under PCA face various restrictions such as a limit on the expansion of their branch networks, while some are restricted from lending activities as well. “Weaker banks will have to depend on a capital infusion by the government, but others will have to have fend for themselves through steps such as the sale of non-core assets and internal accruals,” says Mr Kumar.
In October 2017, the government announced a massive public sector bank recapitalisation plan of Rs2110bn spread over two years, of which Rs900bn was disbursed in financial year 2018. The Moody’s-ICRA report observes that while the recapitalisation plan for financial year 2019 will help public sector banks meet their regulatory capital requirements, it may not be sufficient to support credit growth.
NPAs have peaked in March 2018, the bankruptcy code is in place and time-bound resolutions are in progress
“The public sector banks’ capital shortfalls are larger than the scale that the government had expected when it announced the recapitalisation in October 2017, mainly because the banks have failed to raise additional capital from the market and it may be difficult for them to raise more capital given the substantial decline in their share prices since the beginning of 2018,” Moody’s vice-president and senior credit officer, Alka Anbarasu, said in a press release.
A period of correction
Local media reports suggest that given their dismal performance, more public sector banks may be placed under corrective action. Mr Diwanji of EY notes that PCA by itself might not be sufficient. Indian Overseas Bank, which has the second highest NPA ratio in the industry of 25.28%, has been under PCA for two years and is showing few signs of improvement.
“More than mere supervision, there needs to be a concrete approach for dealing with distressed public sector banks, involving a high amount of capital infusion followed by a focus on process improvement,” says Mr Diwanji. “Once banks are strengthened, they could be considered for consolidation.”
As public sector banks struggle to cope, the field has opened up for private sector banks. “With public sector banks facing near-term concerns over high NPAs and capitalisation, and foreign banks facing internal constraints over expansion, the private sector lenders have managed to increase their market share,” says Yes Bank’s Mr Kapoor. On the credit side, he says, the market share of private sector banks, including small finance banks, grew from about 24% in December 2015 to 30% in December 2017, while the market share of public sector banks including regional rural banks has fallen from 71% to about 66%. Mr Kapoor says that a similar trend is observeable in deposits.
Tech opportunities
Dipak Gupta, joint managing director at Kotak Mahindra Bank, concurs that there is tremendous potential for private sector banks in India, most significantly in the retail banking and consumer credit area. “There is a huge potential for using digital banking in the retail and small and medium-sized enterprise [SME] segments, which is where the opportunities will arise in the next two to three years,” he says. Two-thirds of Kotak’s portfolio focuses on the retail and SME sector. Mr Gupta notes that over the past 18 months, the government has facilitated the creation of a technology framework for retail payments, which has opened up several opportunities. “The interesting feature of technology is that it is agnostic to customers and where they reside,” he says. “Increasingly, the same applies to banking relationships as well.”
A concentrated focus on the retail sector has proven extremely successful at Bandhan Bank, India’s youngest private sector bank, launched in 2015. For financial year 2018, Bandhan reported a 20% growth in net profit, a 37.4% growth in advances and 45.8% deposits growth. The bank’s origins are in the microfinance segment, which remains a key focus area. “Retail banking has tremendous opportunities. We are primarily focusing on the retail and SME area, especially the rural sector,” says Bandhan Bank CEO Chandra Shekhar Ghosh. “Future growth lies in rural India.”
In financial year 2014, retail accounted for only 17% of the Indian banking industry’s total loan portfolio, while today nearly 50% of all loans disbursed are retail loans. Private sector banks have traditionally dominated this segment, but public sector banks such as SBI are aggressively targeting this space as well. SBI’s retail loan portfolio grew by 13.55% in financial year 2018.
“Most banks are covering up their losses through retail banking portfolios. However, keeping a strong watch on NPAs and credit scoring is very important as well,” says Mr Diwanji. Kotak Mahindra Bank’s Mr Gupta adds: “While a lot of attention, thus far, has been on NPAs on the corporate side, banks need to keep a close watch on other business segments too.” He points out that the SME sector was negatively affected by the implementation of a hastily implemented indirect tax policy and demonetisation in 2016, which led to high-value cash being suddenly withdrawn from the market. The negative impact of this may not be visible now, says Mr Gupta, but may show up at a later point as NPAs.
Herd mentality
At present, bad loans in the retail segment are still around the 2% mark. This is causing a “herd movement among bankers to grow retail credit and the personal loan segment”, RBI deputy governor NS Vishwanathan cautioned in a recent speech. “This is not a risk-free segment and banks should not see it as the grand panacea for their problem-riddled corporate loan book. There are risks here too that should be properly assessed, priced and mitigated.”
Risk management is definitely vital for India's banks given the spate of frauds in the banking industry. The PNB scandal may have hit the headlines, but according to local media reports the RBI informed a Parliamentary Committee that in the past three financial years, there have been 15,673 incidents of fraud, worth a total of Rs749.93bn. Banks need to focus on operational risk management and internal controls, according to Mr Kumar of SBI. “Pre-sanction loan analysis and post-sanction loan monitoring and key processes need to be put in place, along with systems that provide early warning signals,” he says. “There are many technology tools available. To be effective, banks need to adopt and integrate these with organisational processes.”
