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Asia-PacificNovember 2 2015

How sustainable are India's public sector banks?

India's public sector banks remain the weakest link in the country's banking industry. How are the central bank's repo rate cut and the government's capital infusions affecting these lenders? 
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Ballooning non-performing loans (NPLs), over-banking and lethargic reform are causing India’s banks to punch below their weight, with public sector banks often epitomising the industry’s inefficiencies and inertia. Recent policy announcements are underscoring these shortcomings, although there are signs of improvement in asset quality and better management.  

The Reserve Bank of India (RBI) cut the repurchase agreement (repo) rate by 50 basis points (bps) in late September, adding to the pressure on Indian public banks’ margins. This comes at a time when high NPLs continue to impact on public banks’ books, albeit with some isolated improvements. To add to this, in August 2015 the Indian government promised more capital infusions for public banks to ensure that they will comply with Basel III capital regulation by 2019 – a further reminder of how vulnerable these lenders still are. 

Structural reforms and greater efficiency are needed in sectors generating NPLs in the first place – infrastructure, mining and power. But extricating the banking sector from the political mire blocking bank consolidation is equally essential to bring the industry back to health, according to market participants. 

RBI easing 

The RBI dropped the repo rate to a four-and-a-half year low of 6.75% on September 29 in an attempt to stave off fears of a slowdown in the Indian economy. A number of banks lowered their base rates in response to stimulate lending demand. In the public sphere, State Bank of India (SBI) – the largest bank in the country – sliced its base rate by 40bps in early October to the lowest level in the market at 9.3%; Bank of Baroda chopped 25bps off to reach a 9.65% base rate; while Bank of India and Andhra Bank also cut base rates by 25bps to 9.7% and 9.75%, respectively.

“The market is moving downwards, so you can’t keep your own rates unchanged after the central bank announces easing,” says a senior executive at one of the public banks.

These cuts could hurt public banks’ margins the most, however, since about 70% of their loan books are linked to base rates. But RBI governor Raghuram Rajan says there is further room for banks to cut lending rates.

“Rate cuts are expected to be transmitted not just through interest rates on credit, but also through interest rates on deposits. Hence, net interest margins [NIMs] need not necessarily be affected. Besides NIMs, banks' earnings depend on several other factors such as fee-based income, cost of operations, etc,” one RBI official told The Banker.

A short-term issue

Geeta Chugh, senior director for south and south-east Asia financial institutions at Standard & Poor's (S&P), sees the rate cut only as a short-term problem. “There will be marginal pressure on banks in the short term because assets will get re-priced faster than liabilities, but it is not a major long-term issue,” she says. But Ms Chugh still has reservations on the efficacy of the rate cut. "A 50bps interest rate cut is not going to drive international investors’ decisions to increase investment in India, [for instance]. [It] will reduce the burden on the corporate sector, but it is so marginal. This alone will not drive credit growth. There are far more structural and fundamental issues to be tackled," she says.

Among the public banks, SBI is not troubled by the RBI’s rate cut since the bank started decreasing its own deposit rate in September 2014 on expectations of quantitative easing. “Deposits tend to get re-priced [after a base rate cut] with a time lag. Ours have been re-pricing for almost 12 months now,” says Anshula Kant, SBI’s chief financial officer.

“[Also], just over 42% of our deposits are interest rate agnostic since they are in the form of current or savings accounts. There might be some pressure, but as bond yields come off [after the repo rate cut], we expect an upside in our portfolio. This will make up for a lot of potential loss in margins,”  adds Ms Kant. 

To sustain margins in such a tricky market, SBI is minimising costs by not fully replacing retiring staff – it has cut 8000 to 10,000 staff in the past two years – by cutting back on conventional branches and their onerous rent costs and by investing in technology advancement. “We are trying to use fewer people and more technology,” says Ms Kant. 

Deteriorating assets 

Despite technological advancements among the top public lenders, India’s banking sector is still grappling with deteriorating asset quality. Poor economic performance and slow policy reform in recent years have led to a stall in scores of infrastructure, mining and power projects. Low commodity prices are also damaging these sectors. This in turn has dampened corporate credit demand and has inflated bad loans, which have nearly doubled since 2012, crossing Rs2500bn ($40bn), according to the RBI. This is more than 4% of total bank loans. 

Public banks have performed the worst. This year, they recorded the highest share of stressed advances (the combination of restructured standard advances and NPLs) in the industry, at 13.48%. The private banks’ ratio was only 4.63%, by comparison. At 5.43%, public banks’ gross NPL ratio this year is more than twice that of the private sector, at 2.2%, and is higher than the 4.62% industry figure, according to the RBI. 

Even the strongest public banks have a considerable NPL problem. Among the top 10 Indian banks by Tier 1 capital, public banks carry the five highest NPL ratios, according to The Banker Database. This year, Punjab National Bank is the worst performer at 6.55%, followed by IDBI at 5.88%, Bank of India at 5.39%, SBI at 4.25% and Canara Bank at 3.89%. 

Mid-tier public lenders face even harsher conditions. In early October, the RBI announced a “prompt corrective action” on Indian Overseas Bank (IOB) to improve its internal control and consolidate its activities. According to S&P, IOB’s NPL ratio soared to the highest among all Indian banks rated by the agency at 9.4% in June 2015, from 5.8% a year prior. 

Private Indian banks in The Banker’s top 10 ranking are doing far better. Their NPL ratios range from 0.9% to 1.85%, save for ICICI with a ratio of 3.78%.

Signs of improvement 

Though NPLs continue increasing, Ms Chugh argues the pace of NPL growth in India is slowing down in some cases. “We have seen NPLs peaking in the private sector and in SBI. But smaller and medium-sized public banks are still showing high NPLs and they continue increasing,” she says. 

“Slippages continue at fairly high levels but this year’s values are definitely lower than last year’s,” adds SBI’s Ms Kant. 

This materialised after SBI consciously lost loan market share over the past year to focus on top-quality borrowers. “We have been discriminating in assessing credit risk. We are doing this in a much more systematic and professional manner,” says Ms Kant. SBI’s risk assessment now includes big data analytics and monitoring cash flows of its small and medium-sized enterprises or agriculture sector clients, where it is possible. 

More broadly, now that state institutions have recognised a large part of their stressed assets, the combination of lower interest rates, potential economic growth and sustained reforms in struggling sectors might turn the NPL story around, according to market participants. 

“It is a bad period, but a greater commonality of approach and professionalism [in facing these difficulties] have changed how things are done in the country for the better of the banking system,” says a public bank senior executive. 

The RBI is also optimistic. “Stressed assets seem to be plateauing. Recent decisions relating to coal, road and power sectors have instilled confidence that banks' assets in these sectors will have less stress, though steel sector continues to be stressful,” says an RBI official. 

Enough capital? 

There may be gradual improvements in the NPL space, but public banks’ deteriorating asset quality remains crucial as Indian lenders work towards full Basel III capital regulation compliance by 2019. And the outlook is not exactly rosy. Weakening asset quality has resulted in low net interest margins and high credit costs. Indian public banks’ return on average assets have dropped from 1% in 2011 to approximately 0.5% in 2015. This has reduced their return on equity from 17% to 8% in the same period, according to S&P. 

What is more, raising capital for public banks remains tricky internally – due to poor asset quality – and externally: several lenders trade below book value, which makes it hard to access equity capital markets

In support of public banks, in August this year the state announced it will inject Rs700bn in capital to all public lenders between fiscal years 2016 and 2019; that it will increase capital allocation for fiscal year 2016; and will make further capital infusions if necessary. This comes as a policy reversal compared with fiscal year 2015, when the government allocated capital only to India’s nine most profitable public banks. 

The RBI official says of this turnaround: “The government is [a] majority shareholder in all public sector banks. The government's decision to allocate capital to all public sector banks shows its commitment, and [this move] is welcome.” 

But despite the state’s increased efforts, an S&P report describes these capital infusions as “just a breather”. The expected annual increase in Tier 1 capital ratios for public banks in 2016 – 15bps above the March 2015 levels on average, if risk-weighted assets grow at 10% – remains insufficient to hit Basel III requirements in 2019. 

Indian public banks will need Rs1400bn in additional capital, double the government’s earmarked infusion, to meet these requirements, and an additional Rs800bn for NPL provisions and slippages from standard restructured loans, according to S&P. 

Consolidation needed 

So, as margins decrease and both capital requirements and stressed advances grow, how can public banks survive and thrive? 

Many market participants say consolidation is one of the answers. Though politically sensitive, incorporating the weakest public banks with low capitalisations and profits into larger institutions could be essential to strengthening the industry. 

Some analysts believe consolidation might take up to three years to materialise. But talks of the government setting up a holding company that will hold all of the state’s public bank shares by as early as 2016 could be a step forward. “It could play a facilitator role in urging banks towards mergers and acquisitions,” says Ms Chugh. 

The Indian government’s decision to allocate capital only to the nine most profitable public banks in 2014 had left analysts hopeful. Many saw this as an indirect form of consolidation – the weakest banks would have been forced to consider a merger or acquisition to survive. But the government’s U-turn (allocating capital to all public banks starting in 2016) has been perceived asa sign that India’s public banks still require full government support. 

This is not testament to a tenable banking sector. If systemically important public banks are to stand on their own two feet, subsidised capital infusions will not make them sustainable. Deeper, sector-wide reforms and a serious take on banking consolidation will.

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