Indian banks are grappling with non-performing assets and a move towards mergers pushed by the central bank. How are they coping with Covid-19?
In the wake of the global Covid-19 pandemic, the Indian government implemented a stringent 21-day lockdown from March 24, 2020, with the aim of halting the spread of the coronavirus.
There were only around 500 officially recorded cases in India at that time, but in the first week of June, as the country prepared to ease out of the extended lockdown, the total number of cases had zoomed up to beyond a quarter of a million, the fifth highest in the world. More worryingly, the numbers showed no signs of abating.
The lockdown may have, at best, temporarily slowed down the spread of the virus. However, the prolonged business shutdown, among the harshest in the world, has ended up extensively damaging an economy that was already struggling before the pandemic struck. Gross domestic product (GDP) growth was at a decade low of 4.2% in financial year 2019/20, just concluded in March 2020, against 6.1% in 2018/19 and 8.3% in 2016/17.
Unforeseen severity
The impact of the coronavirus was far more severe than initially anticipated, said Shaktikanta Das, governor of the Reserve Bank of India (RBI), the country’s central bank, at a press conference on May 22. He said all sectors apart from agriculture were deeply impacted by the lockdown, demand had collapsed and there was a deep slump in private consumption. The RBI believes that India’s GDP growth for the present financial year, 2020/21, will be pushed into negative territory.
“Real GDP will certainly be negative for this financial year. The question is whether it will be closer to zero or -10%. We are in a storm that is changing direction every day and we have to learn to navigate,” says Dipak Gupta, joint managing director at Kotak Mahindra Bank, the fourth largest private sector bank in the country.
He adds: “In other countries that are facing an economic slowdown because of Covid-19, governments have mainly provided fiscal support via direct cash injections, but in India the focus has been primarily on liquidity support.”
Government support
The Indian government announced a Rs20,000bn ($263bn) economic package to kickstart the economy comprising several reforms, along with liquidity and fiscal measures. It includes credit guarantees for micro, small and medium-sized enterprises (MSMEs), a six-month moratorium on term loan repayments, suspension of fresh insolvency and bankruptcy proceedings against defaulters for one year, and policy rate cuts by the RBI.
Rajnish Kumar, chairman of government-owned State Bank of India (SBI), India’s largest bank, observes: “The need is for more money to be pumped into the system, but the government’s ability to provide a large fiscal stimulus is very constrained. Since 60% of the banking sector in India is government owned, the government is providing risk capital and using public sector banks to leverage the system by providing loans.”
Nonetheless, credit growth remains tepid. Pointing out that banks are flush with funds, Mr Kumar says: “Deposits were taking place even during the lockdown but credit off-take is impacted. In the past few years, the retail sector saw the highest credit growth, but with impending job losses, the focus is now on saving rather than borrowing. For larger corporates, normal activity needs to resume for lending to happen. MSMEs have received the maximum support from the government in the economic package and we expect to see some growth here.”
Credit growth takes a hit
India-based credit rating agency Crisil has forecast bank credit growth in this financial year will likely nosedive to a multi-decade low of 0.1%, down from the 8-9% predicted before the pandemic struck and 6% in 2019/20. Crisil says while corporate credit will be hit the hardest, retail lending – which accounts for about a fourth of overall credit – is also expected to fall sharply to low single digits from an average growth in the mid-teens over the past couple of years. Crisil expects the government stimulus package to boost MSME loans, which it predicts will grow at 6-7% in the current fiscal year.
Mr Gupta of Kotak Mahindra Bank says: “There is lots of liquidity in the market, but the problem is that there is a huge risk aversion, and we are not able to find acceptable credit to lend to.”
Rather than largely rate reduction or liquidity support as the RBI has been doing, Mr Gupta says that banks need mechanisms of risk reduction to boost lending, as has been done for MSMEs through the credit guarantee schemes. Such measures, he says, need to be extended for large corporates too, which account for nearly half of the total credit in the economy.
Non-performing woes
Non-performing assets (NPAs) remain a key concern for Indian banks. The pandemic and associated lockdown are expected to exacerbate the NPA situation. Credit rating agency Fitch has estimated that Indian banks’ NPAs could rise in excess of 500 basis points (bps), or even double, over the next two years, subject to economic recovery.
NPAs have been the proverbial millstone around the neck of the banking industry since 2015, when the RBI mandated banks to start recognising bad loans hidden on their balance sheets. Most of these loans were disbursed during the booming mid-2000s period and subsequently turned sour as the economy slowed. As banks were forced to reveal bad loans, they had to increase provisions; this in turn reduced their profitability and weakened their balance sheets.
According to RBI data, Indian banks’ gross NPAs rose from Rs3120bn in March 2015 to Rs9400bn in September 2019. The gross NPA ratio – the proportion of bad loans as a percentage of total loans – increased from 4.45% in March 2015 to a high of 11.6% in March 2018, subsequently improving to 9.1% as at the end of September 2019.
SBI’s Mr Kumar says public sector banks had completed the process of recognising bad loans before the pandemic struck: “In the last three years a lot of clean-up happened in public sector banks. There was recapitalisation and all public sector banks increased their cover for NPAs. As of the end of FY2019/20, public sector banks were in a better position than three years back.”
Saswata Guha, director, financial institutions, at Fitch’s Mumbai office, says: “Before the pandemic hit Indian shores, the number of NPAs were coming down though the slow pace of recoveries was disappointing. The NPA base is so huge that without adequate recoveries, impaired assets remain a big challenge.” The increase in NPAs in the coming months will be driven by higher fresh slippages and lower loan growth, he says.
Public banks suffering
Public sector banks, which account for around 90% of NPAs, will be the most impacted. Already, Mr Guha notes, nearly two-thirds of some public sector bank loan books and one-third of large private sector bank loan books are under moratorium.
Mr Gupta says: “Earlier, NPAs were around large core sectors like infrastructure and power. Over the last year, the MSME sector was getting squeezed. Now because of Covid-19, sectors like real estate, hospitality, airlines and tourism have also been impacted. In due course, the retail sector too will be impacted. Job losses and salary cuts are imminent. It’s a chain. This chain will only get broken when the broader economy gets moving. The only silver lining is that agriculture is in a good shape. Rural India may be slightly better off.”
Amitabh Chaudhry, managing director and CEO of Axis Bank, the country’s third largest private sector bank, says: “In the financial year 2019/20, the Indian banking sector was decisively coming out of the NPA crisis. Most private sector banks were working on improving their internal risk management processes and some banks had transitioned to new leadership. Over the past year, we saw innumerable frauds surface at regular intervals, large shadow banks struggled, a cooperative bank failed and Yes Bank also had its issues. However, RBI and the industry together had handled the crises well and we were well on our way to resolution.
“However, with the pandemic, the situation has changed dramatically. Large proportion of assets are under moratorium while the banking system at the same time is seen as the main instrument for economic recovery.”
“The economic pain is being shared by the government, banks and borrowers. The question is how much time it will take for economic activity to come back to normal. If it takes time then the government has to step in because banks may become reluctant to lend more money,” he adds.
As the economic fallout from the coronavirus weakens banks' financial profiles, there is a growing concern about their capital positions. Mr Gupta says: “Capital is one of the biggest challenges, especially for public sector banks. Low capital poses a serious risk, with banks seeing rising stress on asset quality and low profitability.”
In a recent report, Indian credit rating agency ICRA estimated public sector banks would require Rs450-825bn in capital in the current financial year. ICRA says before the pandemic struck, the expectation was that public sector bank asset quality and profitability would improve and the capital needed would be around Rs100-200bn, which they could raise from the market.
In February 2020’s budget announcement, the Indian government did not announce any capital infusion plans. However, with investor appetite remaining weak in the current environment, government intervention will be needed. In the past five years, the government has injected around Rs3000bn into public sector banks.
Merger activity
In 2019, in an effort to strengthen public sector banks, the Indian government undertook a massive bank consolidation, with 10 public sector banks merged into four. The RBI hailed these mergers as transformational for the Indian banking sector in its December 2019 report, ‘Trends and Progress of Banking 2018-19’. “With the emergence of stronger, well-capitalised banks aided by cutting-edge technology and state-of-the-art payment systems, Indian banks have the potential to become global banking leaders,” the RBI said.
Earlier in 2017, SBI had absorbed five of its associate banks along with Bharatiya Mahila Bank, and in financial year 2018-19, Vijaya Bank and Dena Bank had merged with Bank of Baroda. In the latest round of mergers, effective April 1, 2020, Punjab National Bank took over Oriental Bank of Commerce and United Bank of India; Syndicate Bank merged into Canara Bank; Andhra Bank and Corporation Bank merged with Union Bank of India; and Allahabad Bank was subsumed into Indian Bank.
Following this consolidation exercise, there are 12 public sector banks in the country today, against 27 in 2017. Seven of the top 10 banks in the country by size are also expected to be public sector banks. SBI remains the largest in the country, with assets totalling $556.8bn.
Less fragmented
“The practice of having four or five pillar banks, which is visible in many Asian markets, that support the large credit needs of the economy and are supported by smaller special purpose banks, is perhaps the ecosystem that is more suitable for a large growing economy like India,” says Fitch’s Mr Guha. Looking at the public sector bank mergers, he remarks that a less fragmented banking system is much more efficient.
“A fragmented banking system is generally counterproductive and potentially detrimental to efficiency. Recoveries too have been impacted in recent years, as getting banks’ consensus on resolution has been an issue,” he says. However, he cautions that mergers are not the solution to the NPA problem and that cost savings offered by mergers are only reflected in the medium to long term. The Rs10bn cost savings from Bank of Baroda’s merger, he says, are only expected to accrue over a period of five years.
Ideally, the mergers should have been done when credit growth was in place, says EY India’s financial services leader Abizer Diwanji. “Mergers take over one to 1.5 years to get implemented. This is a big problem when credit is lagging.” Outlining the benefits of mergers, he says: “Mergers solve one big problem of public sector banks, which is size. Mergers offer better resilience and more efficient deployment of capital from a return on equity perspective. Also with scale, the ability to absorb and resolve shocks is better.
“Otherwise, all other issues that public sector banks face, such as talent, technology and governance, are issues that would remain. I think overall, private governance and government ownership is the best bet for these banks.”
Banking industry consultant Ashvin Parekh cautions that the Indian government’s “one-size-fits-all” approach may prove counterproductive to the banking sector. While SBI’s consolidation process went through smoothly, he points out Bank of Baroda is facing challenges in merging technology platforms. “The government should have only focused on one or two mergers at a time. If the top management at leading public sector banks are busy with operational issues regarding a merger, they will not be able to find time to focus on other critical issues such as credit growth,” he argues.
Private sector strength
Given the many challenges facing public sector banks, there is a strong possibility in the coming years they may secede market dominance to private sector banks, says Mr Parekh. The RBI’s December ‘Report on trend and progress of banking in India 2018-19’, highlighted that while private sector banks account for less than a third of assets of scheduled commercial banks (SCBs) in India, they led the expansion in the consolidated balance sheet of SCBs, offsetting the deceleration posted by public sector banks.
In the past decade, public sector banks’ market share of the banking system’s assets has dropped from around 75% to 60%, while private sector banks’ market share has grown from around 20% to 30%. Mr Parekh expects this to continue. “The next 10 years belongs to private sector banks. They will go out and raise a capital, and use the MSME opportunity offered by the economic package in a constructive manner,” he says. “They have the necessary bandwidth, management capability and a huge digital connection with their customers too.”
He points out, however, that SBI, which has more than 20% market share of the Indian banking sector, is an exception among public sector banks. “SBI has very good systems and a solid management cadre. Other public sector banks are nearly two years behind in terms of systems and processes – governance is their weakest point.”
Governance has also roiled Indian private sector banks in recent years, in cases where either the bank board has not been able to provide adequate checks and balances for major shareholders-cum-CEOs or star CEOs. The most recent example of this was at private lender Yes Bank, which had long been regarded as a star performer.
In recent years, however, the bank struggled with rising NPAs, was pulled up by the regulator for under-reporting, and with a weakening balance sheet, started witnessing a run on deposits. Even after its major shareholder-CEO was replaced with a new management, the bank was unable to attract fresh capital and had to be rescued earlier this year by a consortium of banks led by SBI.
The problems at Yes Bank do not reflect on other private lenders, says EY’s Mr Diwanji. He also believes that it will be able to ride out the storm. “Yes Bank has a very good tech platform and very good transaction banking business. They just need to focus on reviving their wholesale business. We don’t expect the multiple banks ownership structure lasting for too long. Ultimately revival and sale will happen.”
Mr Kumar at SBI, which owns a 49% stake in Yes Bank, says: “Governance was the key problem at Yes Bank. They suffered because of reckless lending. With management changes and prudential lending norms, they should be able to come back on track. It has a very strong franchise and technology platform.”
Tech stars
Banks that focus on technology are better placed to provide services in a post-Covid-19 world, says Mr Kumar. During the lockdown period, SBI processed 6000-7000 loans online daily. “Going ahead, business models have to undergo a change. Digital is the way to go. Over the years, customers have become more accepting of digital channels and banks have to build their business proposition around the same.”
Mr Gupta of Kotak Mahindra Bank concurs: “To remain agile and sharp, banks will have to invest far more heavily on technology. We have to use digital to acquire customers as well as service their needs.”
