The country’s largest bank the State Bank of India (SBI) declared its results for the period October to December 2015 (or what analysts like to call the third quarter) yesterday. And the results were disastrous with the net profit falling by 61.7%.
The second largest public sector bank, the Punjab National Bank, declared its results for October to December 2015, earlier this week. And its results were even more disastrous than that of SBI, with the net profit falling by 93%. In fact, the bank would have made huge losses if not for tax reversals of Rs 910 crore.
Banking is a stable business, where banks borrow at a certain rate of interest and lend at a slightly higher rate of interest. Of course everybody who takes a loan does not repay it. But if banks keep provisioning (i.e. setting aside money) for such loans in a proper way, such a huge fall in net profit, can only happen under exceptional circumstances.
Over the last one year, I have written in great detail about the mess that public sector banks are in. And it’s all coming out in the open now. In fact, many banks have been evergreening their loans by giving fresh loans to borrowers so that previous loans can be repaid.
Further, they have been under-declaring their level of bad loans by restructuring loans and kicking the can down the road. Nearly 40% of the restructured loans have gone bad over the last two to three years.
When a bank restructures a loan it allows the borrower a certain moratorium period of few years, in which the borrower has to pay only the interest on the loan. In some cases, interest also does not have to be paid. This is done in the hope that after the moratorium the borrower would have managed to turn around the business and be in a position to repay the loan. In some other cases, the tenure of the loan is increased.
But this facility has been abused by the banks, and loans which were bad in the first place (i.e. the borrower was not in a position to repay it), have also been restructured. This has allowed banks to pass off bad loans as restructured loans and continue to present a rosy set of numbers.
The Reserve Bank of India governor Raghuram Rajan calls this the band-aid approach. In fact, this approach entails banks giving fresh loans to the promoter as well. As Rajan said in a speech he made yesterday: “There are two polar approaches to loan stress. One is to apply band aids to keep the loan current, and hope that time and growth will set the project back on track. Sometimes this works. But most of the time, the low growth that precipitated the stress persists. The fresh lending intended to keep the original loan current grows. Facing large and potentially unpayable debt, the promoter loses interest, does little to fix existing problems, and the project goes into further losses.”
What Rajan is essentially saying here is that the band-aid approach followed by banks up until now has not been working. And what is needed is essentially a surgery. As Rajan said: “To do deep surgery…the bank has to recognize it has a problem – classify the asset as a Non Performing Asset (NPA).”
A loan is typically declared to be a non-performing asset (or a bad loan), 90 days after the borrower starts defaulting on the interest and principal payments. When this happens a bank can no longer continue to accrue interest on the portion of the loan that remains unpaid. It has to start making provisions i.e. start keeping money aside.
This basically means that the bank starts keeping money aside so that if the loan is totally defaulted on or partially defaulted on or the bank cannot recover enough money from the assets that it has as a collateral, then enough money has been set aside for the losses.
For the first year, after the loan has been categorised as a non performing asset, it is referred to as a sub-standard asset. On this loan, the 15% of the outstanding loan amount needs to be set aside a provision. At the end of the year, the loan becomes a doubtful asset. In this case the scale of provisioning goes up. In the first year that a loan remains a doubtful asset, the level of provisioning has to go up to 25%. In the second year, the level of provisioning has to go up to 50%. And in the third year, the loan is categorised as a loss asset and the provisioning has to go up 100%.
As Rajan said: “If the bank wants to pretend that everything is all right with the loan, it can only apply band aids – for any more drastic action would require NPA classification. Loan classification is merely good accounting…It is accompanied by provisioning, which ensures the bank sets aside a buffer to absorb likely losses. If the losses do not materialize, the bank can write back provisioning to profits. If the losses do materialize, the bank does not have to suddenly declare a big loss, it can set the losses against the prudential provisions it has made. Thus the bank balance sheet then represents a true and fair picture of the bank’s health, as a bank balance sheet is meant to.”
And this is precisely what has happened with banks like State Bank of India and Punjab National Bank. Let’s understand this in the case of the State Bank of India. The non-performing assets of the bank went up by Rs 20,692 crore (or what are referred to as fresh slippages). The number was at Rs 5,875 crore during the period July to September 2015. This implies a huge jump. What does this tell us? It tells us very clearly that the bank is finally recognising that there is a problem and that has led to this huge jump in non-performing assets. And that is a good thing.
The net increase in gross non-performing assets is Rs 15,959 crore after adjusting for recoveries and write-offs (i.e. loans on which 100% provisioning has been carried out).
Given that the fresh slippages have gone up by Rs 20,692 crore, the provisioning against these bad loans (i.e. setting aside money) has also gone up. The provisioning has gone up by 58.9% to Rs 7,645 crore, in comparison to the same period in 2014. This means more money is now being set aside to tackle the problem of bad loans. And this is the main reason why the bank’s net profit fell by 61.7% to Rs 1,115 crore. Interestingly, the operating profit of the bank (earnings before tax and provisioning) went up by 2.25% to Rs 9,598 crore.
This trend is visible right across public sector banks in their third quarter results. It tells us very clearly that the Rajan led RBI is cracking the whip and forcing banks to project a correct state of affairs. And that is a good thing as Rajan explained in his speech. I hope this continues in the coming months because the first step to tackling a problem is to recognise that it exists.
The column originally appeared in Vivek Kaul’s Diary on February 12, 2016